Name That Trade – $VIX Edition

by Dan December 19, 2012 11:36 am • Commentary

With the markets generally sanguine about the potential outcome of the “fiscal cliff” negotiations in Washington, my thought is too take the other side of the general near term complacency as we head into the Holidays.  Enis posted his weekly VIX Futures Snapshot this morning (here), his conclusion regarding the price action in spot and across the futures curve:

As the market has rallied, VIX futures are down 0.25-0.5 point across all maturities in the past week.  Normally, with Christmas and New Year’s both within the next 2 weeks, you would at least see spot VIX tick lower as the market moved higher as options buyers left the market.  But this year, you’re seeing options buyers remain active.  The options market was unconcerned with the fiscal cliff fears at the start of the month, but now it’s starting to show some desire for protection even though the stock market is seemingly giving the all clear signal.  

My sense is that while a compromise is very likely in the next few weeks, we are not likely to get the “grand bargain” that some optimists are hoping for.  We are also in the camp that under most scenarios, we will likely see a “sell the news” reaction.

With the SPX less than 2.5% from the multi-year highs made in Sept, I am inclined to make a short term play that spot VIX will hold the 2 month low of 15 with a decent chance of a spike to the high teens in the coming weeks.  I don’t love initiating this trade on an up day like this (spot VIX up ~6%) but if I am right I may not get another chance soon. The reason the VIX is up today when the market is basically unchanged has to do with the settlement and roll of the VIX futures. Here’s a link to an detailed explanation from Bill Luby who writes the Vix and More Blog reagrding an earlier drop in the VIX due to the roll:

So here’s the trade we were looking to do yesterday, and will keep an eye on if the VIX comes back in over the next few days prior to Christmas. Below is using current prices. When we looked at this trade yesterday it could be put on for a credit.

Possible Trade: VIX ($16.50) Sell the Jan 15 Put to Buy the Jan 17/20 Call Spread for Even Money*

-Sell 1 Jan 15 Put at .50

-Buy 1 Jan 17 Call for 1.15

-Sell 1 Jan 20 Call at .65

Break-Even On Jan Expiration:

-Profits btwn 17 and 20 of up to 3.00, with max gain of 3.00 above 20.00

-Losses below 15

-Important point about this structure  on a mark to market basis, the Put that I am short will gain in value as the VIX goes lower towards my strike and the position will show a loss as the call spread decays on weakness in the underlying.