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Scared? This could be the perfect time to get protection

Monday, 13 Jan 2014 | 1:27 PM ET

Even as stocks see a soft start to the year, investors don't seem to be getting too fearful. In fact, the market's "fear gauge" fell Monday to a low touched only once in the past 10 months, and that could give investors a great chance to get protection.

Traders on the floor of the New York Stock Exchange.
Getty Images
Traders on the floor of the New York Stock Exchange.

The CBOE Volatility Index, or the VIX, charts the prices of options on the S&P 500. And because people more commonly use S&P 500 options to get downside protection than upside exposure, an upward-moving VIX tends to paint a portrait of investors clambering for protection.

In October 2008, the index touched 89.53, but is now trading at around 12. The VIX has dropped 10 percent this year, which is unusual, given that the S&P 500 is also down, and the two indexes have a strong inverse correlation.

(Read more: Volatility could come back big-time—here's why)

"It's kind of rare to see markets go down and volatility to drop," said Brian Stutland of the Stutland Volatility Group. "That tells me that protection has gotten kind of cheap. You're getting good value here by getting some sort of protection."

Perhaps that was the thinking of whoever executed Monday morning's biggest options trade on the VIX: the purchase of 40,500 April 28-strike VIX calls for about $0.45 each. This trade, which cost some $1.8 million, will make money only if the VIX is trading above 28.45 in April—which would be the highest since 2011 and more than double present levels.

Pisani: Look for volatility to spike
CNBC's Bob Pisani looks at the great year for the major indices and explains why volatility has been low.

"This is a cheap hedge bet," Stutland said. "It could be that somebody had $50 million worth of long equity exposure. If you own $50 million worth of the market, you want to have that protected. Well, if the market goes down some 10 percent, you'll lose 5 million. But these calls could go triple in value easily," offsetting equity losses.

For that reason, while Stutland doesn't think the trade will actually make money, "it isn't a bad trade, if you think about it on a risk-reward basis," he said. "It's a way for someone to cheaply protect their portfolio in case something happens."

(Read more: Why earnings might actually start to mean something)

Not everyone is on board with using the VIX in this manner.

"I'm not a big fan of getting long VIX calls to hedge your S&P position," said options trader Scott Nations. "First of all, it doesn't always work—the VIX doesn't always go up just because the S&P goes down. In addition, VIX options are six times more expensive [using a metric of options prices] than options on the S&P 500. So I'd much rather buy long-dated puts on the S&P to hedge an S&P position."

Nations is the creator of VolDex, a new product that measures volatility differently by looking at the prices of options on the SPDR S&P ETF (SPY).

But Stutland emphasizes that whether one uses the VIX or simply S&P 500 puts, the investor should find some way to hedge.

"You may not have $50 million in stocks, but take a few zeros off of this trade and you can do the same thing," he said. "This guy's basically showing you a way to get protection right now."

—By CNBC's Alex Rosenberg. Follow him on Twitter @CNBCAlex.

Follow the show on Twitter: @CNBCOptions.

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