With the VIX getting absolutely destroyed following the successful Fiscal Cliff deal in The Swamp, Dan and I started looking at ways to take advantage of a spot VIX in the mid 14s. The VIX has seen the 14 level a few times over the past year and each time it held as a bottom:
Dan mentioned in his Morning Word that we might look at a similar trade such as the one we highlighted on Dec 19th, which was selling a put and buying an upside call spread. A trade that we didn’t pull the trigger on and one that in hindsight we should have chased.
So with the VIX down at these levels, we are looking at a similar structure that we could do for close to zero cost and that would take advantage of any selloff in the market from this resistance level in the SPX.
The problem we immediately came across is that the VIX futures, which are what the VIX options price off of, are in a steep contango left over from the high vol we just saw into year end. Here are the futures from the CBOE site:
And here’s a funny way to see it reflected in the options:
See the 14 put? It’s 20c bid from Feb all the way to June. In equity options time spreads almost always cost money, but here you can do them for free, seemingly buying time for nothing. This is for two reasons actually:
1) The skew involved with the VIX. The VIX never goes below certain low teen levels so the puts become worthless as you go lower. In other words, there is little demand for the 10, 11, or 12 strike VIX put.
2) The other reason for this right now is the steepness of the curve in the futures as you go farther out. The Jun 14 put is being priced off a higher VIX future than the Feb 14 put. As a result, though the put is priced at the same level (since the higher VIX future level in June is offset by more time to expiry), it would be much more costly to buy the same call spread in June than it would be in Feb (since it’s a higher VIX future level AND more time to expiry).
So when looking for a trade, the curve of the futures becomes an issue because any trade that you put on to take advantage of a low VIX is simultaneously a bet that the futures of that month don’t continue to decline (the curve flatten) to catch up (down?) with the spot VIX. You’re essentially swimming upstream against the curve flattening if spot VIX doesn’t immediately start to go higher.
So this is something we’ll be looking at because we’d really like to put on a long VIX trade at some point, but we need to be very careful due to this factor I just laid out.