VIX Option Hedges Increase, Even As Most Expire Worthless

VIX Option Hedges Increase, Even As Most Expire Worthless VIX Options Hit Record as Investors Brace for Stock Pullback Low readings by the market's so-called fear gauge may be signaling comfort, but a deeper look into the VIX options market shows a record amount of activity in contracts that can protect against a market slide. Investors have snapped up options that pay off if there is a rise in the Chicago Board Options Exchange's Volatility Index (VIX) (VXX), which tends to climb as stock prices drop.  A record 7.5 million contracts were outstanding at the beginning of this week, a rise of 15% over the prior record for so-called open interest set in January.  While bullish and bearish bets on the VIX have been increasing since its introduction six years ago, the pace at which bullish bets have grown has risen sharply in 2013. That is a signal that investors -- wary of the recent rally that has driven the Dow Jones Industrial Average (INDU) (DIA) to a record high - -have ratcheted up portfolio protection. "This is a huge sign of a hedged market," said Mark Sebastian, chief operating officer at OptionPit.  "There has been a slow build in open interest, as more people use this as a hedging vehicle, and as the VIX moves to long-time lows." Amid the relative calm, the VIX has been trading near its lowest levels of the past few years.  The index rose 14% to 15.29 Tuesday, below its 20-year average of 20.68 - closing back down on Thursday to 12.67.  Last week, the VIX fell to a six-year low of 11.30. The VIX is calculated from the prices investors are willing to pay for protective options tied to the Standard & Poor's 500-stock index (SPX) (SPY).  It tends to rise as stocks fall.  VIX options correspond with the underlying futures contract expiring in the same month, rather than on the oft-quoted Volatility Index itself. Many large investors, including mutual funds, hedge funds and pension funds, have traditionally hedged their stock portfolios with options on the S&P 500 stock index -- the contracts off which the VIX is calculated. But in recent years, these large institutional investors have increasingly turned to options on the VIX itself.  As the VIX moves lower, the cost of options on the index has moved lower as well. VIX options can be used to hedge against market declines because of the way the value of the options increases with market volatility . Because the index often moves sharply, that value can increase or decrease dramatically in a short time. Last Friday, the cost of a "call" looking for a 10% rise in April VIX futures was $100 a contract.  As of Tuesday, the cost of that contract had risen 65% to $165 a contract as the underlying April future rose 9.9% in value.  Those increases came as the VIX jumped 18% when the S&P 500 slipped 0.6% Monday, and as the index rose 14% on Tuesday. Call options give buyers the right to buy an asset at a set price, locking in that level even if the asset appreciates. It has been a record-breaking six months for active call options in the VIX.  Those are contracts that would be used to hedge a stock portfolio: If stocks fall and the VIX rises, those options would increase in value.  The number of outstanding options that pay off if there is a rise in the fear gauge soared to 7.5 million after Monday's trading, one million more contracts than when the prior record was set in January. Over the past year, VIX options hedges have largely expired unused . In 2012, 95% of all expiring call options expired worthless, according to options-data firm Trade Alert.  At the current price, 95% of March call options are set to expire worthless. Courtesy of Kaitlyn Kiernan, wsj.com