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Broad Indexes Bracing for a Volatility Spike?

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The slow grind continued in the first week of June. The S&P 500 rose in four of five trading sessions and settled the week at record highs. Overall volumes have been light and, by some measures, volatility has plummeted to multi-year lows. Yet, one player in the options market last week committed significant capital in a trade takes advantage of current volatility levels and may indicate a view that action will may get more interesting in the weeks ahead.

Not all stocks are participating equally in the recent rally. In fact, on Friday, as the S&P 500 scored new highs, only 99 of its components, or less than 20%, of the index, moved to 52-week highs. Meanwhile, the recent advance has been on diminishing volume. According to Bloomberg, 1.8 billion shares of S&P 500 companies traded daily during the month of May, which was the slowest pace since 2008.

Volatility has plummeted. The 30-day Statistical Volatility or Historical Volatility, which is computed as the annualized standard deviation using closing prices for the past thirty days, of the S&P 500 fell to only 7.5% last week and the lowest levels since August 2013. The S&P 500 has not seen a 20-point daily swing since April 9 and the average daily move over the past month is about eight points, or 0.4%.

Consequently, CBOE Volatility Index (VIX), which tracks the expected or implied volatility priced into a strip of S&P 500 Index (.SPX) options, is falling to low levels as well. The index dropped below 11.0 last week for the first time since early-2007. Interestingly, on Friday, as the index closed at 10.73 and its lowest levels in seven years, only 115 of S&P 500 components of the S&P 500, or 23% of the index, also saw 30-day implied volatility falling to 52-week lows.

On the options front, the largest blocks of options traded so far in June 2014 were in the VIX pit last Thursday and seem to be expressing the view that the low volatility won't last. With the index near 11:00, the Initiator bought 144,000 July 13-16 risk reversals (buying call/selling put) for a $0.19 debit and sold 288,000 July 20 calls for $0.27 and bought 144,000 September 20 calls for $0.94.

Looking at trade history and open interest, the activity in the July and September 20 calls was closing. It was covering a position (short calendar spread) opened in May. Meanwhile, the massive July 13 16 risk-reversal was opening and apparently expressing the view that market volatility might see a substantial spike prior to the July expiration, which is in 36 days for VIX options.

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At the time of publication, Henry Schwartz held no positions in the stocks or issues mentioned.

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