Wall Street's 'fear gauge' is doing something unusual as stocks hit record highs

Tuesday's rally was so intense that it's shaking up some of the usual assumptions around volatility pricing.

The Cboe Volatility Index (VIX) – sometimes referred to as the stock market's "fear gauge" – rose a full point in the midst of Tuesday's breakout 1.8% rally in the S&P 500 . As stocks extended gains in the first hour of trading Wednesday, the volatility gauge was up alongside equities again. As the market softened and reversed, the VIX fell.

The VIX index and the S&P 500 in the past five trading days It's a clear-cut example of something that happens about 20% of the time: Stocks and the VIX move together about 20% of the time. This tends to occur when the VIX is low and a large amount of call buying occurs in a rapidly rising market. That call buying forces the VIX to rise even as stocks are going up, which has occurred this week.

More than 4 million S&P 500 index calls traded on Cboe Tuesday, a new all-time record volume, according to the exchange. At the same time, at Nasdaq, the price for call options betting on a one-standard deviation move in the Nasdaq 100 surged 42% — the biggest single-day jump in five years, according to Nations Indexes data. That extreme demand – while entirely bullish in sentiment – lifts the prices of options and implied volatility, which in turns keeps the VIX bid alongside stocks. In other words, exuberant call buying is driving the VIX higher. On Tuesday, the put-to-call ratio fell to 0.83, the second lowest reading on record.

It also creates some unique setups for both bullish and bearish traders.

The first implication is that bulls should be wary of owning far out-of-the-money call options. Generally, when the price of something goes up 42% overnight, it's not exactly a discount bargain anymore. In the case of options, where implied volatility is a key contributor to a contract's value, it creates a potential double-whammy scenario for call buyers when both the price of the underlying asset and its volatility drops. This is precisely what happened midday Wednesday as stocks and the VIX declined.

On the flipside, with the VIX still sitting at or near long-term averages, it creates a potential win-win scenario for investors who don't want to sell stocks but are worried about big swings. If days like Tuesday repeat, stocks and hedges can work together. If the market falls sharply, VIX will likely also rise, so long-vol hedges will work.

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