Traders are betting big on a stock market shock

Volatility traders haven’t been this sure of a stock market shock in more than two years.

These investors buy and sell options on the CBOE Volatility Index — or VIX — as they predict swings (or a lack of) in the S&P 500. The VIX typically spikes when stocks fall, and falls in a steadily rising market. And right now traders are not betting that things will stay quiet.

The cost of bets on a quiet market — used either as hedges by traders who expect volatility, or as directional wagers on fewer price swings — is lower than its been at any point since October 2015. That’s relative to the cost of an increase.

In other words, volatility traders have taken the restrictor plates off their bullish VIX bet, and are fully embracing the idea of a stock market shock.

This degree of confidence over increased turbulence has manifested itself in the exchange-traded fund market. That’s home to the iPath S&P 500 VIX Short Term Futures ETN, the biggest and most heavily-traded VIX-linked product, which absorbed a net $US219 million last month. To put the inflows in context, consider that the long-VIX instrument saw a $US41 million outflow in the six weeks leading up to July.

Vix skew
Bets on a VIX decline are at the lowest since October 2015, relative to wagers on an increase. This is a bullish signal for the VIX, which can be read as investors expecting a stock market shock. Business Insider / Andy Kiersz, data from Bloomberg

These latest developments come on the heels of several high-profile bullish VIX bets.

The week before last, a mystery trader made a massive bet that the VIX will surge. If successful, it would yield a $US262 million payout, according to a person familiar with the trade. The investor implemented a bullish call spread strategy using hundreds of thousands of VIX options.

And then there’s the recently-unmasked volatility vigilante, 50 Cent. He’s been spending hundreds of millions of dollars to buy exposure on a VIX spike, but doing so in bite-sized pieces.

VIX bullishness extends to Jeffrey Gundlach, the founder of hedge fund DoubleLine Capital. He said last week that his firm purchased some five-month put options on the S&P 500 as the VIX sunk to a record low.

“This is like free money,” said Gundlach, who is known on Wall Street as the Bond King. “We are in a seasonally weak period for stocks but more importantly, we think the VIX was really, really low. So the S&P puts are going long volatility.”