Wall Street’s Hot Volatility Trade Right Now Is Betting on Calm

(Bloomberg) -- The carnage of the last seven days will have made millions for traders who wagered on panic breaking out in the stock market. Now strategists say there’s money to be made in betting everything cools down.

It’s time to consider shorting volatility on the S&P 500 Index, according to Wells Fargo & Co.’s Pravit Chintawongvanich, who echoes a slew of sell-side voices. Last week’s rout pushed expected swings on the gauge in the near-term to “extreme levels,” so the equity derivatives strategist recommends selling put options on the benchmark to profit from an imminent decline in jitters.

“The VIX is now over 3 standard deviations high relative to where 1-month realized vol would ‘predict’ it to be,” Chintawongvanich wrote in a note on Friday. “Although realized vol is also high, it is difficult for the S&P to move 3% a day for an extended period.”

Wall Street’s Hot Volatility Trade Right Now Is Betting on Calm

Difficult, though not impossible. Futures on America’s benchmark gauge rallied as much as 2.4% on Monday morning amid hopes central banks can cushion the economic blow of the coronovirus. But the rally then fizzled out with the gauge 0.2% lower at 8:17 a.m. in New York as confirmed cases of the illness continued to rise.

Last week’s epic sell-off in stocks powered the Cboe Volatility Index, a measure of expected price swings known as the VIX, to its highest level since 2015 on Friday. While a surge in implied volatility isn’t surprising given the scale of the stock retreat, strategists are beginning to argue it’s overdone.

Dean Curnutt, CEO of Macro Risk Advisors, reckons the VIX’s most recent close at 40 is unlikely to hold for an extended period, particularly if the Federal Reserve helps put a floor under markets. The measure was trading at 41.70 on Monday morning after the futures rally fizzled.

Over at Tallbacken Capital Advisors, Michael Purves has been buying put options on the VIX in a bet the gauge will fall, citing the massive gap between implied and realized swings. “These premiums mean there is a substantial buffer even if realized volatility jumps substantially higher in the coming weeks,” he wrote in a note last week.

As recently as Thursday, some vol watchers were warning that the VIX could stay elevated following a close of 39 that day. But the dramatic intraday surge at the end of the week appears to have convinced them a pullback is due.

That might have tested traders who started betting on a return to calm even sooner. Yannis Couletsis at Credence Capital began selling equity index and single-name options last Monday, at the beginning of the worst week for stocks since the financial crisis.

The risks are high for those who get it wrong: Options sellers expose themselves to the prospect of unlimited losses in tail scenarios, while the pain for buyers is limited to the premium paid.

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