A Potentially Dangerous Trend for Traders

Focus: STOCKS

Lawrence McMillan Image Lawrence McMillan Founder and President, McMillan Analysis Corporation

If you own protection, it might be worth holding onto it when the market is declining, rather than trying to sell it at the first indication that you have a profit on it, says technical expert and options specialist Larry McMillan.

When S&P 500 Index (SPX) broke down below 2420 last week, and there was a bit of panic selling, the term structure of the VIX futures, and of the CBOE Volatility Indices (VIX) immediately inverted in the front end, and the futures went to a discount. That was a bit surprising and certainly premature from a historical perspective.

After all, if the VIX futures are going to trade at a discount with VIX at 15, where are they going to be if VIX explodes to 40 in a real market decline? Yes, it turns out that the market rebounded, so that “discount” was justified by what happened later, but was it really justified at the time? I don’t think so.

The reason I’m even bringing this is up is that this type of action could result in a nasty melt-down some day. If everyone piles into short VIX futures at 14, with VIX at 15, there is going to have to be some eventual panic buying of VIX futures if the market continues to plunge (and simultaneously, if there is panic buying of VIX futures, there is going to be panic selling of S&P futures).

It seems that the volatility derivatives market is replete with traders who might be long some protection but want to sell it at the first sign of a market decline. This is the dangerous trend to which the title of this article refers.

Selling off protection quickly doesn’t make any sense to me. Who would sell off their protection at the first sign of market weakness? Not someone who is truly worried about protecting his portfolio–but rather someone eager to register a profit on his VIX purchases. So far, that type of activity has worked, but the day will come when those selling off protection early will be looking to buy it back at much higher prices (probably right at the eventual bottom of a nasty market decline).

I’m not saying it will be another Crash of ‘87, but the fact that S&P futures went to a 7-point discount in the afternoon of the Crash (October 19, 1987) and stayed there, produced a wave of selling by index arbs, which then spilled over into mass panic.

These things can balloon. If you own protection, it might be worth holding onto it when the market is declining, rather than trying to sell it at the first indication that you have a profit on it. If things turn nasty, others will eventually be begging you to sell your protection to them at much higher prices.

Just for historical reference, in the aftermath of the Crash, S&P 100 Index (OEX) puts that were 80 points in the money were selling for 120 or even higher–a fact probably long lost in the historical garbage can.

But if it can happen once, it can happen again. So think twice before you take a quick profit on your protective positions.

Learn more about Larry McMillan and options strategy here

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