The VIX has been on a roller coaster the past few weeks, spiking as high as 50 on August 24th and then settling back near historical means with the slow creep higher in the SPX over the past week or so. Yesterday it briefly dropped into a 17 handle following the Fed announcement. But now that the much debated FOMC meeting is gone, with no change to rates, the uncertainty in markets seems to still be there and the VIX is probably not properly representing the volatility that remains in global risk assets and how that volatility could quickly revisit US equities. Put it this way. The Fed essentially stated that this month wasn’t the right time due to global economic concerns. That doesn’t seem like the type of environment one wants to sell vol in.
The next FOMC meeting is October 28th but most feel the chances of a rate raise one month after the statement today is unlikely. But the bigger story to us is not when the Fed will raise rates but what will be the causes behind them continuing to kick the can down the road. Be careful what you wish for. Keeping ZIRP going until the Spring is probably not bullish for US equities.
So at some point soon we will go back to a trade structure we’ve used in the past. Normally we like to do this trade when the VIX is near historical lows. But in this case we want to time it after the big move lower in volatility over the past few weeks with the idea that at least 1 more bout of equity selling is on the horizon.
Yesterday afternoon this trade was about .15 debit. Today, with the market down and the VIX higher it’s trading about 1.00. We’re not pulling the trigger now because we prefer to do these trades closer to even money, so we would want to see it fall below .50 again:
Hypothetical Trade – Buy the VIX Oct 16 – 22/30 call spread risk reversal
- Sell to open 1 Oct 16 put
- Buy to open 1 Oct 22 call
- Sell to open 1 Oct 30 call
If we don’t see another day like yesterday where the VIX drops sharply below 20 we may have to recalibrate and change the strikes. We’d prefer not having to sell a higher put strike so it may be the case we just raise the strikes (or tighten) on the call spread portion. The reason for that is that a short put at 16 is very different than one at 17 considering the risk of this position. The risk on this position is basically what you pay plus the chance of the VIX settling on expiration below the put strike. It’s unlikely that we see a 12 or 13 VIX antyime soon with what’s gone on lately but a VIX in the 15-16 level is quite possible if the market starts heading back towards the highs. Therefore a put sale at 16 is likely only risking 1-2 with the chance of making up to 8 (in the case of the 22/30 call spread. Therefore we’d prefer not to go any higher on a put sale than 16 because we don;t want to have a ton of risk on this trade.
This trade works somewhat as a portfolio hedge but not exactly as timing to expiration is crucial. If volatility spikes to 30 in the next few days this doesn’t act as great as a hedge as if volatility spiked a few weeks from now. Essentially the way that works is that a spike to 30 on Monday means that the call spread portion wouldn’t be realized as the 30 calls would still be worth a ton at that point. But if the spike to 30 happened a few days before October expiration most of the value of that call spread would be realized. If it settled above 30 on October expiration the full value of that call spread would be realized.
But it is great tail risk hedge in case things go berzerk like they did in late August. Because if this VIX is a lot higher than 30 it doesn’t really matter when it happens. If the VIX is 50 next week the call spread would realize almost all its value simply on deltas. So we’re not doing this trade just yet but we’ll update if and when we pull the trigger.