By Saqib Iqbal Ahmed
NEW YORK (Reuters) - Even as U.S. stocks remain near highs and daily gyrations for stock prices are the most subdued in more than half a century, some options-based measures point to investors positioning for increased volatility.
The CBOE Volatility Index <.VIX>, better known as the VIX and the most widely followed barometer of expected near-term stock market volatility, recently fell to an all-time low of 8.84.
While the low implies little fear of volatility pop in the S&P 500 Index <.SPX>, VIX options positioning says differently.
"There's been a lot more interest in hedging with VIX options for a volatility spike in the past couple of weeks," said Nitin Saksena, head of U.S. equity derivatives research at Bank of America Merrill Lynch.
The number of open call options on the VIX outnumber put options by nearly four-to-one, among the highest ever, according to data provider Trade Alert.
Call options convey the right to buy the underlying security at a fixed price in the future, while put options convey the opposite right. VIX calls, which appreciate in value when stock market volatility spikes, are used to profit from a pick-up in volatility.
Options positioning for the S&P 500 Index and its tracking exchange-traded fund <SPY.P>, show a similar concentration in positions benefiting from falling stock prices, but are not as pronounced.
"If you time it right and pick the right strikes you will make more money betting on a VIX rise than on an S&P fall," said Matt Thompson co-head of Volatility Group at Typhon Capital LLC, in Chicago.
Increased interest in hedging with VIX options is a departure from the recent trend where increasingly fleeting volatility spikes have left traders struggling to make money on their VIX hedges.
To be sure, positioning for higher volatility is no guarantee that will occur.
Low interest rates and inflation, the perception the Federal Reserve will rush in to rescue tanking markets and investors' tendency to treat every pullback as a buying opportunity still support the idea that low volatility can linger for longer.
"Be very careful when trading long volatility because low volatility can last a long time," said Stephen Aniston, president of investment adviser Black Peak Capital, in Connecticut.
"The longest low volatility runs have been almost two years in length. So this low VIX environment could potentially last another year."
Still, should volatility spike suddenly, positioning in VIX-linked exchange traded products (ETPs) could further roil markets, strategists warn.
While the VIX, being an index, is not tradable in itself, the launch of VIX futures in 2004, VIX options in 2006 and the roll-out of sophisticated ETPs starting in 2009, provided investors the first opportunity to trade pure volatility.
These ETPs now command roughly $4 billion in assets under management.
On a daily basis, these products rebalance their exposure by buying VIX futures when they are rising and selling VIX futures when they are falling. That amplifies moves in both directions.
A sudden and sharp drop in the S&P 500 at a time of low volatility presents a big risk for the overall market, but especially in the VIX complex, Morgan Stanley strategist Chris Metli recently wrote clients.
While VIX futures are a relatively small market when compared to the S&P 500 Index, it is possible that increased buying of VIX futures at a time when markets are already stressed could have a knock-on effect on the S&P options and the benchmark index itself, Typhon's Thompson said.
"Depending on who you talk to, in that extreme scenario there could be a feedback loop."
Additionally, for inverse ETPs, which fall when the VIX rises, a one-day drop of more than 80 percent might trigger unwinding of the products by the issuers.
"People are concerned that the inverse products might cease to exist," BAML's Saksena said.
Saksena stressed that in the current low volatility environment having a one day drop of more than four percent would be tantamount to the kind of shock experienced when the S&P 500 fell over 20 percent on the "Black Monday" crash of Oct. 19, 1987.
(Reporting by Saqib Iqbal Ahmed; Editing by Daniel Bases, Bernard Orr)