Some Traders Are Betting That the Market Will Tumble Soon. What You Need to Know. - Barron's

Donald Trump Photograph by Nicholas Kamm/AFP/Getty Images

When you feel most comfortable is when you should feel the most uncomfortable. Some institutional investors are starting to feel very uncomfortable—and it may be time to follow their lead.

Maintaining a healthy skepticism toward markets and market narratives is largely how shrewd investors catch big turns and avoid the deadfalls that harm others. Yet it is increasingly hard to be a contrarian. Anyone who has analyzed too much and doubted this historic stock rally is ending the decade poorer than tyros who think less and invest more.

In the final days of 2019, however, some signs suggest that savvy investors are preparing for something to go wrong—very wrong. After months of talking about the somnolent nature of the VIX, and the historically low costs protecting portfolios, institutional investors are returning to the hedging markets in a big way.

On Dec. 17, Wall Street went agog over an investor who bought about 130,000 January $22 calls, paying 46 cents to 54 cents a contract when the VIX was 12. On Dec. 18, another big trade roiled markets. Someone bought 50,000 VIX January $22 calls for about 59 cents, and 70,000 January $25 calls for 44 cents.

These trades were rather stunning because of their extraordinary size and because the VIX, currently under 13, would have to double for them to pay out. They are basically betting that a miniature Armageddon will occur in about a month.

Of course, no one can completely know the motivations of others, especially those with large, complicated portfolios. For all we know, these trades could represent something far more benign than a selloff.

Still, it’s fair to wonder just what outcomes these trades are protecting against. Impeachment? President Donald Trump will probably be remembered as the most pro-stock market leader in the history of America and yet stocks keep rising. In fact, with the VIX below 13, his impeachment apparently isn’t even viewed as a risk. That disconnect between Wall Street and Washington seems odd.

Another possibility: a trade-war mishap. Market speculation anticipates that Trump and China’s Xi Jinping will meet in Davos, Switzerland, at the World Economic Forum that is scheduled from Jan. 21 to Jan. 24. They might even sign a trade deal. Then again, the trade-war sparring buddies may decide to start sparring once again, causing the VIX to surge, says Susquehanna Financial Group’s Alison Edwards.

It is also true that many high-yield bond investors buy VIX calls to hedge their portfolios. Those types of bonds are the fixed-income equivalent of stock, and thus investors often buy VIX calls because they are easier to buy and sell than other products. And some observers are worried about a junk-bond meltdown.

We could theorize for days—we are human, after all, and tend to focus on linear interpretations, especially if they can be used to make a dramatic point that supports the prevalent thinking and mood—but that is probably useless. Most often, markets rise and fall when least expected, not because of a well-crafted narrative.

We also know that low volatility has largely begot low volatility for the past decade. Is that different with Trump’s impeachment proceeding or if the trade war detente gives way?

Perhaps the best response to those big VIX trades, the ones seeking protection to something, somewhere on the horizon, is to note that the stock market is trading near a record high, that the fear gauge remains unusually low, and that something tends to give when extreme conditions exist.

In that case, a little insurance never hurts.

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Some Traders Are Betting That the Market Will Tumble Soon. What You Need to Know. - Barron's
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