Spot VIX has had a fairly historic period, putting in 52 week lows in early August, seven year highs on August 24th, and now a decline back towards the historical mean. Vol is coming out of equities in a big way this week, with front month VIX Futures about to go below second month. After a week of massive gains in the S&P 500 (SPX), the spot VIX is now about 19:
Of course any trade we place in the VIX is actually in the VIX futures. Those have held a little higher but not by much and are now under 20.
We feel it’s unlikely that the recent volatility abates simply because the Fed suddenly seems less likely to raise interest rates over the next few months. The reasons for the FOMC not raising rates are ultimately the source of the recent volatility.
And if YUM’s 19% decline (after issuing disappointing results last night) is a precursor to the sort of single stock volatility that earnings may bring, then last week’s rally of more than 5% offers a great opportunity to take some equity exposure off of the table.
With that in mind we want to look out to November and position for a return of the VIX to higher levels. That expiration also catches the October 28th FOMC meeting. That should provide another bout of volatility either before or after, and possibly both.
This is a strategy we like to employ every so often. The trade involves a short put but with the VIX that’s not risk down to zero as there is a floor in the low teens. And after periods of volatility that floor is more likely the mid teens. So here is the trade:
Trade – Bought the VIX ($19) Nov 17put 22/30 call spread risk reversal for .20
- Sold to open 1 Nov 17 put at .80
- Bought to open 1 Nov 22 call for 1.65
- Sold to open 1 Nov 30 call at .65
Break-Even on Nov 18th Expiration:
Profits: above 22.20, of up to 7.80 up to 30, max gain of 7.80 at 30 or higher
Losses:between $17 and $22 lose 20 cents paid for structure. Below $17 lose 20 cents and penny for penny with the index.
Rationale: It’s unlikely we see the VIX below 15 or 16 over the next few months and therefore the risk on this trade is probably around $2. The reward is more and all we need to realize some of that potential is one spike in the VIX between now and November expiration. Of course timing is crucial on profit potential. If a spike happens sooner than later we need it to be big in order to truly realize big profits on this trade. If it happens closer to November expiration we need less of a spike. This holds true if this trade is used as a portfolio hedge. The VIX is cash settlement on expiration. Ideally we’d take the trade off before then but the risk on this trade is really that the VIX drops back towards it’s lows and the short 17 put is in the money. We think that is unlikely but even if it happened probably is not by much.