Traders are aggressively purchasing VIX call options! Strategists warn: It could become a significant catalyst for US stock volatility.

Strategists warn that the popularity of hedging US stock market risk by buying bullish options on the Chicago Board Options Exchange's volatility index has become a potential source of instability. Data show that more than 1m contracts traded on the VIX on Tuesday, the sixth time this year that the volume has reached such a high level. Charlie McElligott, cross-asset strategist at Nomura, said in a note this week that the new trades were making option traders “extremely bearish on VIX gamma”, estimating that traders would have to buy about $150m of Vega (the sensitivity of the option price to changes in the volatility of the underlying asset) for every 10-point rise in volatility. Mr McElligott said this meant traders were preparing for a potential volatility collapse in US stocks, setting the stage for a larger de-risking event. While the market has not yet seen extreme volatility, he called the current position distribution a “hypothetical but unsettling stress test”, simulating the chain reaction that could be triggered by a sudden spike in volatility. “If the VIX rebounds near its March expiry, dealers and hedge funds will be forced to buy VIX futures to maintain their hedges, and volatility could again spike,” he said. As Mr McElligott sounded the alarm, investors overall remained bullish on US stocks. The S&P 500 closed at a record high on Wednesday, with exposure from hedge funds and leveraged exchange traded funds growing, and mutual funds holding low cash levels, while retail investor demand was high. Scott Rubner, strategist and managing director of global markets at Goldman, warned last week that a bear market was about to hit US stocks, saying that the current market participants were saturated and the momentum to buy on dips was weakening. He noted: “Everyone is in, including retail traders, 401(k) flows, year-end asset allocation and corporate cash. The dynamics of demand are changing rapidly and we are nearing the seasonal negative phase.”
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