Cue up the hyperanalysis, there’s some VIX OTM call trading going on……

The CBOE Volatility Index (.VIX) is down .28 to 20.88, as the S&P 500 (.SPX) has traded in a relatively narrow 10 point range Tuesday. The S&P 500 is nearly unchanged midday. In the options market, VIX July 42.5 calls are the day’s most actively traded contract, with more almost 87K traded. A lot of that volume is due to ratio spread trading, where a strategist was apparently bought 4 July 42 calls for every 1 (short) July 32.5 call. More than 25K July 32.5 calls have also traded today. They paid $1 per 1×4, according to a contact on the floor. The position is tied to VIX futures at 32.6 (might be a roll of long calls).

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Not sure I’ve ever seen a single trade get this much press. But Don Fishback finds this reference to The Most Important Options Transaction Ever.

Can’t take it anymore. I’ve seen this too many times to not comment. Yesterday, a reporter for the Washington Post’s “The Ticker” wrote:

“At least one trader today placed a nearly $1 million bet that the VIX will rise above 45 by July, buying several thousand option calls.”

No, No, NO!

Just because somebody bought a million dollars worth of options does NOT mean that that person thinks volatility is going to 45. People buy options for 2 reasons: speculation and hedging. There is simply no way to know from the information presented in the article that this VIX call buyer was a hedger or a speculator. If the person was a hedger, then by definition they think the most likely event is that volatility is not going to go to 45, but they want to be protected in case it does. They bought volatility insurance!

It refers of course to the 20,000 lot of VIX 45-55 call spreads that went up last week.

Basically, following options order flow for directional clues is more art than science. When I was on the floor way back when, you kind of sort of kind of could get a feel for which players you wanted to follow and which ones you wanted to fade. But even that’s far from a path to riches.

And like Don says, who ever knows exactly what the player is doing overall. Even if you did, it’s still not a lock you want to follow them directionally or not. And let’s put this particular trade in perspective. Again, it was a low delta, way OTM call spread in the VIX. Remember it’s a VIX future, which this far out we figure will track about 40-50% of the VIX move. And even with the recent rally, the VIX still has a 31 full. Yes, you don’t need the VIX to actually go to 45 and above to win big on the trade. But as Don notes, 38 sure would work. We’re nowhere near that yet, and truthfully to get there you’d need to see the VIX in the 40’s as July would move to a discount.

Selling naked puts on the VIX just prior to expiration can be a surprisingly low risk volatility play.

Normally, selling naked puts is a dangerous strategy because of the risk that negative news can overwhelm the underlying, causing it to gap down and create a large loss. With the VIX, however, spikes are almost always upward, because while threats to equities are relatively easy to identify, it is much more difficult to discern when these threats are suddenly extinguished.

For this reason – and because the VIX has lately shown some reluctance to drop below the recent floor of 27 – selling a naked put on the VIX is a lot less risky than selling naked puts on other securities. Risk to the down side is definitely limited, yet the limitations are not perfectly mathematically quantifiable.

A sale of the June 30 put illustrates one potential naked put sale opportunity. The profit and loss chart below outlines what the trade looks like. With yesterday’s closing price of 30.81, the trade is profitable if the VIX rises, drifts sideways or loses up to 1.61 prior to tomorrow’s special opening quotation. The gain is $80 per contract. The profit and loss chart shows that a loss of $170 per contract occurs at 27.50. Assuming 27.00 is a floor in the VIX, then the maximum loss is likely to be capped at $220. While a 12.3% drop in the VIX in one day cannot be ruled out, it is obviously not a very likely scenario.

Reminder: VIX options expire on Wednesdays. The June VIX options expire June 17^th this cycle. The last trading day for these options is today, Tuesday, June 16^rd. (See the 2009 options expiration calendar for the full 2009 options expiration schedule.)

[source: optionsXpress]

Disclosure: Neutral position in VIX via options at time of writing.

SVNT closed Monday at $9.27 so buying the $10 straddle would cost $4 paying the asking price.

You see from the profit graph above that SVNT has to move a lot for the straddle to make money. The blue line is the profit graph for Tuesday. Here is what Tuesday’s graph looks like if the volatility collapses from 400% to 180% (July implied volatility).

Tuesday’s return graph drops a lot, hugging the expiration return graph.

Dual Calendar Spread

Since the straddle costs $4, the options market is saying that the most likely outcome of the hearing Tuesday is that SVNT move to $6 or to $14. So we can try to build the dual calendar out of -3 June 5 P ($0.45 bid) and +3 Sep 5 P ($1.25 ask) and -1 June 12.5 C ($0.65 bid) and +1 Sep 12.5 C ($2.15 ask). This would cost $489 to put on.

If the June volatility drops to the Sep level it is good for the position.
Tuesday’s blue graph moves up to the expiration graph (Friday).