With the stock market up approximately 26% this year, many investors are starting to become worried. Since you can’t predict the top, it does make sense to take some insurance ahead of what will be a volatile first half in 2014.

It looks like we are most likely going to see the Federal Reserve begin shifting monetary policy, and this is starting to worry large investors as they’re beginning to take precautions.

On December 12, a large institution bought over $5 million of call options for the Volatility Index (VIX), expecting it to jump over the next few months.

Specifically, the trader bought 40,000 of the 22 April calls at $1.28. The volatility index currently at 15.4, this is an extremely bullish viewpoint betting that volatility will rise by the April expiry date.

What is this investor doing?

More likely this is a very large institution that is currently long the market, and is looking to take an insurance policy in case of a sell off.

The way it works is that as stocks sell off, volatility increases. This investor is most likely a long-term holder of their positions and doesn’t want to sell outright.

This is a good lesson for investors, especially long-term holders. Let’s say you have a core position that you don’t want to sell, adding options to help hedge downside risks is a good strategy.

The biggest problem for many investors is once they sell a stock that has gone up, when do they get back in?

Even sophisticated institutions have difficulty with timing, so they employ advanced techniques such as adding option trades to help mitigate overall risks.

Another approach to hedge your portfolio is to add short positions.
I believe having some portion of your portfolio long and some portion short makes strategic sense.

With the volatility index beginning to move up, I think this is an early warning that the stock market is very vulnerable to a selloff in the first quarter. With the Federal Reserve about to make a significant change in policy, this could be the catalyst to drive stocks lower.

However, the Federal Reserve could also continue pumping money into the system, which will drive stocks higher.

This is the conundrum that many institutions are dealing with, and the reason why this particular trader is adding such a large option position to their portfolio.

The real lesson, and one you have heard many times before, is this…

To find out what this lesson is, click here to find out in Profit Behind The Blog @ BehindWallStreet.com.

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