Tim Boyle/Bloomberg
 
 
The CBOE Volatility Index, or VIX, dropped to 8.84 on Wednesday after the Federal Reserve finished a two-day rate-setting committee meeting. That marked its lowest level since December, 1993.

The intraday low sparked a shock-and-awe moment as a generation of investors had never seen the fear gauge at such an extraordinarily low level. The reaction among many traders was to buy relatively inexpensive upside VIX calls before everyone else got the same idea.

While there is always a brisk market in VIX $20 strike calls, interest in the trade is peaking as VIX ebbs ever lower. VIX was recently around 9.30. For investors in a fully invested portfolio this is tantamount to buying cheap insurance trades that pay off if VIX rises above 20. The fear gauge’s long-term average is around 19.

What could cause VIX to rally? A sharp drop in the stock market. What could cause stocks to drop? Your guess is as good as mine, but these are the cold facts about VIX calls.

The September $20 VIX call is trading around 43 cents. The October $20 VIX call is trading around 70 cents. The calls are relatively inexpensive and the expirations capture two of the most volatile months in the stock market.
 
Larry McMillan, a respected voice in the options market, told clients that yesterday’s sub-10 VIX close was the 10th consecutive day VIX had closed below 10 — an all-time record.

“Previously, the Standard & Poor’s 500 Index did respond with a short-lived correction, but that has not been the case on this lowest and most severe probe below 10 by VIX,” McMillan, president of McMillan Analysis Corp., wrote in a premarket note to his clients.

In the past, we’ve cautioned investors against trading VIX.

Many people think they are trading the fear gauge that everyone quotes when they are buying VIX calls. They don’t realize VIX options track VIX futures and that they cannot really trade the fear gauge.

But frankly, upside VIX call trades seem too attractive these days to pass up. Timing is a big difficulty, though. Who knows when, or if ever, stocks will snap lower and VIX will pop higher?

While much is always made about big VIX trades, it is critical to understand that the vast majority of the flows are related to investors hedging stocks, high-yield investments, and even structured products. We’ve done our best to talk some sense to nonsense, but a cottage industry now exists that twists VIX trades into doomsday predictions for the stock market.

About a week ago, for example, Bank of America Merrill Lynch executed a huge VIX trade. The bank bought 260,000 VIX October $15 calls, and sold about the same number of VIX October $12 calls, and then sold about 500,000 VIX October $25 calls. The trade generated a credit of $5 million. The bank crossed about 80% of the trade — that means taking the other side — and the VIX crowd handled the rest. The trade was portrayed in some media reports as someone making a massive bet VIX would soon surge. The reality is less dramatic.

“A hedge for sure,” said someone with close knowledge of the trade. “I suspect versus long stock or a structured product. It’s too big a trade to be a speculation.”

Because the VIX market is tough for most investors to analyze and track, our standard recommendation for investors who ask about trading volatility is to advise them to sell puts and buy shares of CBOE. The exchange-operator CBOE Holdings (ticker: CBOE) owns the VIX complex and thus makes money off the growing fascination that now surrounds the fear gauge.
 
 
STEVEN SEARS is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.