November expiration VIX options expire on Wednesday, November 21. Even with Hurricane Sandy potentally reducing two trading days in this expiration cycle, there is a good chance that another record in call open interest is achieved, following three consecutive months of record call open interest before the expiration of the front-month option contract (see the chart below). Note that sharp declines in open interest occur when the front-month contract expires. That said, there has been a tendency for call open interest to subsuqently build following each expiration, as many market participants are anxious to replace expiring call contracts to speculate or guard against a sharp downturn in the market related to Europe, earnings, the economy (fiscal cliff). and elections – what we have termed the four “E’s”.
To the extent that the call open interest build origniates from option buyers speculating on a spike in volatility or looking to hedge a long portfolio of equities, we think this is a decent indication of market sentiment. A contrarian would conclude that with everyone on the “long volatility” trade, there is less likelihood of a volatility spike related to a sharply declining market.
The level and recent activity in VIX put open interest, or bets on downside volatility, is also on my radar. Note in March and April, for example, that there was record VIX put open interest, over three million contracts. It was then that the market ran into trouble, with the SPX peaking in late March and bottoming in early-June. Right now, VIX put open interest is around 2.2 million contracts, and there has been very little build since Octobe expiration. This absence of a post-expiration build in put open interst is a rarity.
From a contrarian view, with so few expecting low volatility and the market trading around potential support levels, i.e. SPX 1,400, lower volatility may be just around the corner, to the surpise of VIX option players.
Chart courtesy of TradeAlert