We got a great question in our QnA earlier and I wanted to use use it to expand the answer into a post. Here’s the question:
In light of the belief that we are headed for more volatility, I want to put some protection on. I am trying to decide between SPY put spread, or the VIX.
If I recall correctly, in the past when the VIX gets down to these levels you have detailed a structure where you sell a call spread and finance it with a lower put sale for net zero premium (or close to it). At the moment, pricing on that structure does not appear to be favorable. Would that suggest that SPY or SPX put spreads are a better strategy? Or am I looking at this the wrong way?
Let’s look at some different strategies and see what’s the best option here for a portfolio hedge.
The first thing we want to look at is the VIX trade we’ve done in the past. With the spot VIX getting crushed today, down below 13, it would seem like a great entry on that trade. But, the spot VIX is slightly misleading at the moment as it seems to being hit doubly with the massive up day along with the weekend effect. The futures, which are all that matter to us on this trade, are down but not getting crushed:
As you can see, April (VIX/J5) VIX futures are still nearly 16, and the curve steepens up to almost 18 as we go three months out. This has actually been fairly typical in 2015. The futures are pricing in a decent chance of a return to volatility and sort of shaking off the day to day swings of the spot VIX itself (appropriately!)
But because of that steep curve from spot out to the futures, our preferred trade isn’t exactly a no-brainer here. In fact, if you look at VIX options in April, the 14 put (which is the put I’d like to sell) is only .25, and in June is maybe .30. A sale like that doesn’t pay for much of a call spread. And with the spot VIX below 13 and the S&P 500 headed to new highs, that just doesn’t seem like a great sale at all. So for that trade I think you want to let those futures come in. That trade becomes close to a no brainer when those 14 puts are around to .65 -.75, and a real no brainer when you can sell the 13 puts for 55-60c. That pays for a really nice call spread like the 16/20 or even the 15/20 in those situations. So we’ll have to wait.
If someone put a gun to my head right now and told me I had to come up with a long VIX trade? It’d probably be an out of the money call fly, like the May 17/22/27 for 60 or 65c. Sure. Why not? Well, it would suck if the VIX spiked up to 30 and you would feel like a big dummy for being short deltas in the VIX above 27. But the chances of that are slim and really your biggest risk on that tradeis losing the .65 when the VIX closes below 17.
So I don’t love VIX trades here, but what about the SPY? SPY vol is actually getting pretty low pretty fast:
This means hedges in the SPY are getting cheap, and that’s good! So let’s look at the chart to see where we’d want protection to:
The first obvious level on that chart is down around $200. That’s basically a pullback to those recent selloff levels in December and January. It also happens to be where that rising 200 day moving average is. It’s not entirely unlikely that we’d see something like that this summer if rate fears kick up again. But a simple little 5% correction is probably not worth hedging as it’s likely you’d need to spend more that 1% of the underlying to hedge for that. Why bother, right? So what we’re more interested in is real fears, the kind that take the SPY down towards those October levels. That’s the kind of sell-off that keeps you awake at night wondering if it’s the big one.
And I think you’re going to want to buy some time on a SPY hedge here. The market really doesn’t feel like it’s going down anytime soon does it? So let’s look out to September.
The Sept 200/180 put spread is about $3.40 here. That’s not terrible as it’s about 1.5% of the SPY for protection on about 8% of the index on a correction of about 14%. One could also finance that by selling an upside call if they don’t mind capping some upside. The Sept 225’s at 3.30 make the trade virtually even, but that seems a little tight to me. I’d probably move that up to the 225’s, give myself a little more room to the upside and just spend a little more money for the entire package. It’s probably worth the money to not worry about getting squeezed on the upside so soon.
What about hedges for a milder pull-back with some more at the money strikes? The May 210/200/190 put fly is about 1.30 right here. That’s pretty cheap. A breakeven at $108.70 with a max payout of 8.70 if the SPY pulled back to its 200 day moving average. The big issue with that trade is it’s not really “protection” if the market crashed. It’s targeting a possible and much more likely level. But that’s why I’d do a trade like that in May and not in September.
To sum up, vol is low enough in the SPY that portfolio hedges already make sense. The VIX just isn’t there yet as far as being a no brainer. We’ll be keeping our eye on that though as we’d love to get back in the VIX trade outright at some point this Spring or Summer.