Today is the 25th anniversary of the 1987 market crash, a day when the S&P 500 fell over 20% and traders learned the importance of covering their tail risk. Today it is as imperative as ever to cover your tail risk, and yesterday we saw one trader doing just that. With the January VIX future trading at 19.20, one trader bought 11,000 Jan. 45 VIX calls for $0.30. These calls are 136% out of the money and to many it may seem like wasted money. However, should a black swan event occur between now and January these calls will explode in value as traders scramble to buy portfolio protection and implied volatility skyrockets. There is no shortage of headlines that could come out of Europe, the Middle East, or America that could cause a massive sell off, and that is why we are seeing so many traders hedging right now. At the same time it only takes a glimpse at a chart of the S&P 500 the past year to see that it is a bull market. We want to be invested in the market right now, but also have tight hedges on should the uptrend abruptly reverse. Buying deep out of the money VIX calls is one way to accomplish this, though it can be costly due to options decay and need to be rolled forward at expiration. However, it only takes one extremely volatile day to make this insurance pay for itself. As traders in 1987 will tell you, it was the people with long volatility positions that has the last laugh who were able to stay in the business to trade another day.
The CBOE Correlation Index (KCJ) is close to the lowest level we have seen since it was first listed in 2007. The KCJ measures the implied movement of the S&P 500 components options, compared to the implied movement of the S&P 500 index options. Simply put, the higher the number, the more likely all stocks are going to move together. Conversely, a low number will be characterized by sector rotation, and flat markets; one sector moves higher, another moves lower. (Source: Access Hollywood) Correlation, for lack of a better term, is correlated with volatility. Not surprisingly, 30-day S&P 500 historical volatility is near the low level of 6.5%. Currently at 33.5, KCJ is sitting close to rock bottom, lower than where it was in 2007, (but not lower than where Lindsay Lohan was in 2007). So far this year, the market has been able to grind higher, characterized by leadership in FANG(Facebook Apple/Amazon, Netflix, Google) and sector rotation. A...
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