Forget Rally, Options Traders See Fear Spike Coming

Note: This post was written by Brian Stutland, President of Stutland Equities and a contributor to CNBC's "Options Action."

NYSE traders
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NYSE traders

On Wednesday, we saw large options trades on VIX futures. Traders were betting that the "fear" index would remain in its current range through November expiration. One trader sold the Nov. 16-17 strangle and bought the Nov. 20 call 35,000 times for a net credit of $1.90.

What? English, please! Okay, so here is what the trade is telling you.

The trader believes the VIX will be between 14.10 and 18.90 at Nov. expiration, and is stopping himself out on the upside if he is wrong. The VIX index is a measure of implied volatility in S&P 500 options, and is negatively correlated with the market. Historically, for every 1 percent down move in the S&P 500 , the VIX has increased by 4 percent on average. This can make it a powerful hedge to a stock portfolio.

Therefore, by betting that the VIX moves no higher than 18.90, this trader thinks a sharp decline in the S&P 500 is unlikely. Since September, the VIX has been range-bound between 13.51 and 18.96 and is currently in the middle of this range. This trade is betting that this range will hold for the next 47 days until November expiration.

I like the way this spread was constructed. It has many of the attributes I like to see in my trades: a hedge to limit risk where the trade is most vulnerable, a favorable risk-reward ratio, and break-even points that coincide with major support and resistance levels.

The VIX is a mean-reverting index, and with its 50-day average at 15.79, there a very reasonable chance that the VIX will still be near current levels at November expiration.

Having said that, we continue to hold bull VIX positions to hedge out our portfolios, and Stutland Equities makes a market in hedged VIX option and futures positions.

Brian Stutland is the President of Stutland Equities and a contributor to CNBC's "Options Action."

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