Investors are using options to brace for big swings this week as Wall Street enters the peak of the most volatile month for stocks historically.
Options on the CBOE Volatility Index, Wall Street's so-called fear gauge, were one of the top-traded contracts in the options market as investors made bets on a sharp jump in the index.
This week "is the real start of a month to be nervous about," said Brian Overby, a senior options analyst at online brokerage TradeKing in Charlotte, North Carolina.
"Especially, because the volatility has come off so much, there is a lot of complacency in the market. So if we get one (item of) bad news, that will cause a big jump."
September is typically a weak month for stocks, and volatility reaches its peak as traders are fully back to work from summer holidays.
The largest open interest on VIX options was on the September $45 calls, suggesting some investors were betting on the gauge to double the current level by this week's expiration, said Ryan Detrick, a senior technical analyst at Schaeffer's Investment Research in Cincinnati, Ohio.
"With less than one more week to go, unless something tragic happens, it is unlikely that the VIX would double. But the bottom line is, people are hedging themselves a lot more, preparing themselves for big moves," he said.
On Friday, about 145,000 calls traded in VIX options, which are priced off of VIX futures, versus 46,000 puts, according to options analytic firm Trade Alert.
The VIX closed down 4 percent at 21.99, below its 200-day moving average. But the index was up 3.2 percent last week, having fallen more than 12 percent the previous week.
The index usually has an inverse relationship with the Standard & Poor's 500 benchmark as it tracks option prices that investors are willing to pay as a protection on the underlying stocks.
Bearish sentiment continues
The Dow and S&P 500 both closed last week with a seventh gain in eight sessions in a turnaround period for stocks that has seen investors' worst fears about the economy start to dissipate.
But the gains were made on the second-lightest trading volume of the year so far as investors remained on guard for more deterioration in the market.
Michael Shea, managing partner at Direct Access Partners in New York, said the bears continue to be more active at the high end of the range.
"It's Datapalooza (this) week ... If all the data points in one direction, which is unlikely, you might see a more substantive shift in sentiment. (But) getting a mixed message is the more likely outcome, perpetuating this current inertia we are experiencing," he said.
The week's economic calendar includes retail sales due on Tuesday, industrial production and capacity utilization on Wednesday, the Producer Price Index and jobless claims on Thursday and then the Consumer Price Index and University of Michigan/Thomson Reuters consumer confidence on Friday.
Adding to volatility, Friday also marks the end of the "quadruple witching" period — the quarterly settlement and expiration of four different types of September equity futures and options contracts.
Expiration usually leads to greater volume and volatility as players adjust or exercise their derivative positions.
But the two-day event, which only happens four times a year in March, June, September and December, could stir up more sudden swings in the market as traders close hedging positions or roll them over at the last minute.