Portfolio Protection Trade – $VIX : Our Bread and Butter Vol Play

by Enis November 12, 2013 1:35 pm • Commentary

We received a thought-provoking question yesterday in our Your Questions Answered section of the site from a shrewd subscriber:

Now that VIX is in middle 12 handle, is it worthwhile to consider a trade with risk reversal as we have done earlier?

My response this morning:

It’s a great thought. We’ve been wary since there are no major market catalysts between now and November VIX expiry, but December VIX futures have fallen quite a bit too, and they catch the next FOMC meeting in mid-December. Even if the Fed decides not to taper, the anticipation of that risk should keep VIX Dec futures bid for the next few weeks. We might look at a Dec VIX risk reversal with that in mind.

We have had some success trading VIX risk reversals over the past few months.  Our most recent (and most profitable) trade was taken off in early October, near the height of the market’s anxiety over the political impasse.

This time around, we don’t anticipate any market events that are likely to cause similar volatility.  BUT, the nature of December VIX expiry is essentially identical to what happened on September VIX expiry.  

In late August, I put on this VIX trade with the following rationale:

The VIX expiry falls on the morning of the FOMC September announcement (and Bernanke press conference).  As a result, the actual press release won’t be until later that day, after the VIX will already have expired.  So options traders are likely to remain bid for SPX options on that morning of VIX expiry, which makes us think that VIX expiry will not be a very low print, no matter how quiet the market remains going into the event.  In other words, the Sept 18th FOMC release is the most important Fed meeting in 2013, so options are likely to remain bid ahead of it.

All of that means that we are happy to sell the VIX downside puts in September given the lower than normal probability of a low VIX print.  We can use that premium to buy a VIX call spread in September in case the market’s jitters become more substantial in the coming weeks:

We normally are adverse to selling outright puts, but the nature of this VIX settlement falling on the morning before the FOMC release makes us much more comfortable taking that risk.  As a result, we like the risk/reward of this structure.

Lo and behold, December VIX expiry is on December 18th, which is once again a FOMC release day.  Everything we discussed in our September trade rationale applies for December VIX futures as well.  In the case of the September trade, the Fed decided not to Taper and the VIX got crushed as the market made a new all time high, but since our VIX trade expired in the morning, we ended up with no loss / no gain, no harm, no foul, and a great risk/reward trade in the case that the VIX had rallied ahead of the event.

One main difference is that the Taper anticipation/expectation for December is significantly lower than it was for September.  However, the entry price for the VIX structure with VIX spot below 13 is favorable enough in our view to compensate for that difference.

This is a great trade for portfolio protection since there is no initial premium outlay, but the chance for a nice gain on a swoon is evident.  It also works as a purely speculative trade because the risk of a VIX settlement significantly below 14 is minimal with the FOMC event.  Here’s the trade:

TRADE: Sold the VIX (12.90) Dec 14 Put to Buy the Dec 15/18 Call Spread for Even Money

-Sold 1 Dec 14 Put at .60

-Bought 1 Dec 15 Call for .1.15

-Sold 1 Dec 18 Call at .55

Break-Even on Dec Expiration:

-Profits up to 3.00 between 15 and 18, max profit of 3.00 at 18 or above

-No profit or loss between 14 and 15, structure expires worthless

-Losses below 14 in linear fashion

Trade Rationale:

For those who have margin concerns, you could sell the Dec 14/12 put spread, instead of the Dec 14 put outright.  Moreover, this structure offers very attractive risk/reward for those who are not worried about a VIX settlement much below 14 on Dec 18th.  As we’ve said, we view the risk as minimal with the FOMC release later that day.