A Potentially Dangerous Trend for Traders


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.

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