To The Moon

US stocks $S&P 500(.SPX)$ fell sharply on the day of the trade after positive US labor market data boosted Treasury yields $iShares Core U.S. Aggregate Bond ETF(AGG)$ , which fueled speculation about the Fed taking more aggressive measures against inflation.

$Cboe Volatility Index(VIX)$ , the volatility index, rose 20% in the trading hours and closed up 8.89%. Before yesterday’s rally, VIX has remained at its bottom.

1. What triggers VIX’s surprising surge?

The recent 20% surge in the VIX and the 10-year Treasury yield's rise to 4.08%, back to the high point before the March rate hike, are correlated. For reference, the 10Y Treasury yield reached its peak at 4.2% earlier this year.

After the debt agreement is reached, new Treasury issuances may lead to a forced decrease in bond prices and an increase in yields. The reduction of the Fed reserve balance will result in decreased market liquidity.

2. Why should investors keep close eye on VIX and US Treasury before rate hike?

In the long term, both the VIX and US Treasury yields are expected to decline. However, It is uncertain whether the US Treasury yields and VIX will continue to rise in July.

It is important to monitor the VIX before the next rate hike. The CPI data for June, which will be released next Wednesday, may influence rate hike expectations (market currently expects a 90% probability of 25bps rate hike in July).

3. Hints from options orders: a trader bet on VIX will rise above 45?

A trader believes that the VIX will rise above 45 by mid-October, which would be more than triple its Wednesday close. This level was last seen in April 2020, during the market crash caused by the Covid-19 pandemic.

The trader purchased around 83,000 call contracts that expire on October 18, spending approximately $4.5 million. To offset the cost, they simultaneously sold about 27,700 VIX calls with a strike price of 27 and the same expiration date.

Chris Murphy, co-head of derivatives strategy at Susquehanna International Group, describes this trade as a classic VIX tail hedge.

Bearish sentiment:

Although the trade's size is not particularly significant (with a net expenditure of around $665,000), it reflects a belief that market turbulence will return by the fall after a period of low volatility earlier this summer.

Bullish sentiment:

The trader can earn much premium as he/she sold call of $Cboe Volatility Index(VIX)$ when it surged yesterday. The cost of the trader of betting on VIX’s surge is small.

Its strike price of 27 means that he/she was not betting on VIX rising above 27. Of course, the contracts had another leg with strike price of 45, which can helps the trader reap profits from the small chance of market decline.

How do you expect VIX’s trend in July?

How do you interpret the trader’s bet?

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