Update: Debt Uncertainty, Volatility, and a Way to Play

by CC July 28, 2011 11:46 am • Commentary

Here’s a little update on the how this debt ceiling stuff will likely play out. From Business Insider:

According to congressional sources this is how a deal will play out if everything goes according to plan:

If the Boehner bill makes it to the Senate, Reid has said he will amend it and use it as a “vehicle” for his own plan—giving it expedited consideration in the House.

With just a single vote to raise the debt limit through the end of 2012, Reid will likely offer Republicans some sort of “sweetener” to support his bill, including “triggers”—or mandatory actions that would take effect if the committee’s recommendations were not passed by Congress.

It is almost certain that Reid has the votes for such a compromise plan—as Democrats will back it and Republican Senators are growing frustrated with the tea party’s antics.

The bill would return to the House, where nearly all of the 193 Democrats would back it, and the support of only a few dozen moderate Republicans would be needed to pass it and send it to Obama for his signature.

House Republicans have already exacted multiple victories—$1 for $1 cuts to debt limit increase, no taxes, and deep spending cuts. They would have a hard time defending their desire for a second vote by opposing a bill that actually has more cuts than the Boehner plan (even when war savings are excluded).

Lawmakers are awfully close to a deal today. Let’s hope they can bring it home.

This sounds about right to me. So back to the XIV. The only scenario I see left for a massive pop in volatility on the debt ceiling issue would be if tonight’s House Vote fails. If that were to occur I’d imagine we’d see some chaos tomorrow morning as it would signal that the right wing of the House Republicans won’t go along with any deal. From The Hill:

House Speaker John Boehner (R-Ohio) told Republican lawmakers Thursday he does not yet have the votes to pass his debt-limit bill.

Though members emerged from a closed-door meeting saying they believe the Speaker will secure the 217 he needs by Thursday evening, when the House is set to vote, Boehner will still need to convince dozens of undecided members to back his measure.

“We don’t have the votes, but we’re getting there,” Boehner said in the meeting, according to Rep. Peter King (N.Y.) and other Republicans in the room. King said Boehner was “very low-key” a day after he rallied his troops with the exhortation, “Get your ass in line.”

You can follow the whip count here. As it stands right now, 19 Republicans are “no” votes. 24 “no” votes and Boehner’s proposal cannot pass the House without Democratic votes.

If Boehner gets the votes for his bill, I think we’d see this type of horse trading, described in the Business Insider excerpt above occur over the weekend with a finalized bill ready to presented to the President and signed by Tuesday.

This is a trade that is a bet on timing a little chaos in the market before this mess is ultimately resolved on Tuesday. If resolution were to happen you’d likely see XIV go back to the 18 level. Right now, there isn’t a scenario where the VIX spikes to 30, a point where the odds are really in your favor historically, unless the House vote fails and nothing gets resolved by next week. Then the XIV is alot lower. If the House passes the bill tonight there will likely be a small vol crush with the VIX going back to the high teens and XIV going back towards 18.



Original Post:

A little while back I wrote about trading overall market volatility through ETN’s and the difficulty of trading from the long vol side (VXX.) With what’s going on in D.C. and the uncertainty over how the debt ceiling hostage taking will play out, we may be in a situation where we see a real spike in the VIX in the next few days. That may present an opportunity to play the VIX from the short side.

XIV is an ETN that tracks the daily movement of the short term VIX Futures, inverted, or from the short side. When VIX futures go up, it goes down, when VIX futures go down, it goes up. What’s nice about the product is it doesn’t seem to suffer from the contango issues that its VIX tracking brethren do from the long side. This makes it a good product to try to time pops in the VIX with the idea that when markets then settle, and the VIX futures go back down, one can sell it higher.

I had some success trading this product during the Japan nuclear crisis which followed the horrible earthquake and tsunami. With all the uncertainty surrounding the fate of the Fukushima Power Plant, world markets were crashing and the VIX spiked above 30. The XIV went briefly below 11 at that point. When the news out of Japan started to improve, (with regards to the nuclear crisis element) the VIX came in hard and was trading below 20 just a handful of trading days later. The XIV went from below 11 to above 14 and about a little over a month later was approaching 18.

XIV 6 mo

The VIX is super volatile and it isn’t uncommon for it to make massive daily moves during times of uncertainty, so timing is crucial. XIV tracks short term futures in the VIX which are slightly less volatile as they are are looking forward. But spikey moves in the VIX will drag the futures along with them, at least partially, and the more time the VIX spends higher the more the futures pull towards it.

We may see that sort of scenario play out over the next few days. Keep an eye on both the VIX and the VIX Futures.

What I am looking for is some sort of move by the VIX, which closed today at 23, up towards 30. 30 tends to be a level that the VIX spikes to during uncertain situations that hinge on some sort of news flow. Like what we’re getting out of Washington right now. If all hell breaks lose, like during the credit crisis in late ’08, or even with the Flash Crash last year, it goes much higher.

VIX 5 yr

The good thing is that volatility is mean reverting. So even if you’re wrong, like being too early, you can wait it out. The way I like to trade spikes in volatility is, when I dip my foot in, I make sure I have some bullets left in the chamber in the case that I am early. If, for instance, the VIX were to spike to 30 this week due to the mess in D.C. and I put on the XIV trade discussed here only to have next Tuesday’s deadline pass without a resolution, who knows what will happen with volatility. It could go much higher than 30 (see VIX chart above.) The XIV that I thought was a great buy at 11 could be trading 8. I want to have bullets left to take advantage of that. Eventually vol will come in.

XIV is volatile, and fairly thin, so it tends to trade in fits and starts intraday. Execution timing is pretty crucial. You can also be really wrong really quick. It’s not uncommon for it to move 15% in a day. So it’s not for the feint of heart, nor is it wise to use capital that you can’t stand to see involved in swings like that.

So this is what I will be watching this week if the news gets even crazier out of D.C. I’ll be rooting for cooler heads to prevail for the good of the country, and may even bet on it. I’ll update this post on the site if and when I do pull the trigger.