With the SPX index making all-time highs, VIX spot has moved back to near the 12 level. However, a new all-time high can sometimes be a reason for increased volatility rather than just decreased volatility, a case we laid out for our IBM trade idea last month. In that post, Enis said:
When stocks make new breakouts like this, options oftentimes get bid up as traders prefer to own options to play for a fast move on the breakout rather than buy stock and risk a false breakout scenario. In that sense, IBM’s breakout to new all-time highs presents a likely either/or scenario. EITHER IBM’s breakout holds and the stock continues its march higher like the previous instances in the past 3 years. OR IBM’s breakout today is a false breakout, and IBM breaks back below the prior 212 resistance level, faking out all the new buyers who bought the breakout today.
In either case, this type of setup is conducive to a fast move in either direction. It’s rare that IBM’s stock just sits right above the breakout level. So are option prices expensive as a result?
The same holds true of the SPX index today. Even if the breakout continues, we expect that there will be a sharp selloff at some point in the next couple months simply because the steepness of the ascent signals a more emotional rally. With the VIX at 12, near the lows of the year, the entry for a long VIX related trade is decent:
[caption id="attachment_24642" align="alignnone" width="635"]
VIX spot, 1 year daily chart, Courtesy of Bloomberg[/caption]
TRADE: Sold the VIX (12.46) May 13 Put to buy the May 16 / 19 Call Spread, Collect 0.05
-Sold 1 May 13 put at 0.45
-Bought 1 May 16 call for 1.05
-Sold 1 May 19 call at 0.65
Break-Even on May Expiration:
-Profits up to 3.05 between 16 and 19, max profit of 3.05 at 19 or above
-Profit of 0.05 between 13 and 16, as all options expire worthless
-Losses below 12.95 on a one-for-one basis
Trade Rationale:
The 12 level has been the low in VIX spot, but the front month VIX futures has not gone below 13 this year. Since we’re trading May, the trade will follow the direction of the VIX May futures contract, currently priced at 14.50. So there is some disadvantage to us given the steepness of the futures curve. BUT, even if the market stays quiet, the front month VIX put is only worth 0.50 right now, so if the VIX doesn’t move over the next 6 weeks, we view our likely risk on this trade at around 0.50. On the flip side, if the market does get jittery in the next month, we should have a nice winner on our hands.