Options experts are saying Thursday’s record volume in volatility derivatives bets may signal a dangerous problem with the size of volatility-linked trading products.

The focus is on the CBOE volatility index, a key measure of market expectations for near-term volatility as conveyed by the price of S&P 500 index options. The CBOE announced VIX options volume hit 2.56 million contracts on Thursday, a record for a single day. In addition, VIX futures volume reached 939,000 contracts, another record.

The high volume coincided with a 44 percent spike in the VIX, to 16.04, its highest daily close for the year. The VIX recently hit a record intraday low of 8.84. On Friday afternoon, it was at 14.54.

The volume in VIX “options and futures tells us that yesterday was potentially a more serious event, and validates some of what we have discussed in recent notes about the growing leverage in VIX-linked products,” Macro Risk Advisors head derivatives strategist Pravit Chintawongvanich wrote in a note to clients Friday.

The strategist cited how large future moves in the VIX may be driven by the increased use of volatility exchange-traded products or ETPs.

“Volatility can quickly revert to ‘normal’ levels as we saw yesterday. But starting from low VIX futures levels, that translates into a large percentage move for the VIX ETPs – which in turn translates into a potentially large rebalance, and the potential for the inverse VIX ETPs to be stopped out,” he added.

As a result, Chintawongvanich recommends investors buy put options on the SPDR S&P 500 ETF and the iShares iBoxx $ High Yield Corporate Bond ETF to hedge against further downside volatility. A put option gives the holder the chance to sell an asset at a set price at a point in the future. It’s a bet the asset price will fall.

One accomplished options trader said the dramatic one-day VIX surge Thursday likely stemmed from traders being forced to close out losing volatility positions.

“When I see really out sized moves in VIX like yesterday I have to think the reason isn’t just people scrambling for protection as much as some of the so-called smart money being forced to cover their naked shorts,” CNBC contributor Jon Najarian, founder of Investitute.com, wrote in an email.

“If the market moves too quickly to the short strikes, the trader and or his or her clearing firm are forced to buy back the short positions at the worst possible time, when volatility is elevated,” he added.

Source: Investment Cnbc
All-time record options bets on volatility spook Wall Street over leverage risk