Trade Update – $VIX Call Spread Risk Reversal

by CC November 13, 2015 3:41 pm • Commentary

In early October, following a fairly massive rally in equities from the September lows, we entered a long VIX trade with the idea market volatility was unlikely to abate anytime soon. Here was one of the main thoughts:

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.

Since putting on the trade we’ve seen wild swings in the market to the upside, and now coming back to  where we entered the trade. The SPX was about 2000 when we went long VIX, it went as high as 2100+ and is now back down, approaching 2000 again. The VIX during that time went from 19 (where we entered the trade) to under 14 (!) when markets were at their recent highs and is now back above 20 on this selling. To recap, here was the trade and rationale:

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

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.

We did see the VIX lower than “15 or 16” since putting on the trade but that was a pretty unbelievable rally in equities (and in hindsight, a kinda stupid rally). The point is even volatility to the upside is still volatility and these sorts of moves don’t exactly make stocks look healthy. So now with the market slightly higher than where we went long VIX, the VIX is also higher. THIS MAKES SENSE.

So how do we manage this thing? There are two ways to think about this trade. If one did this trade simply as a trade that VIX would spike, you want to treat it as such and trade out of it on any reasonable profit (right now the trade is a small profit, worth about .50 with VIX 20.55). If we saw a quick puke in the market from here, that may be you chance to make decent money on it as a trade. But if this was a portfolio hedge you have it right where you want it and if we see further market weakness on Monday and an even higher VIX you may want to consider rolling the trade out to December. Since the trade expires next week (remember VIX futures settle on Wednesday, not Friday) that .50 current value is at risk of being worthless if the VIX stays under 22. The risk of it settling below 17 still exists as well, so if those go offered at .10 or even .05 it makes sense to start by closing that strike at the very least.

Since this was just a trade for us, here’s what we’re going to do. We’re going to take off our short put risk, and roll down our short call strike and be left with a long call spread for even with no risk:

UPDATE: vs VIX at $20.50

  • Bought to close the VIX Nov 17 puts for .20
  • Bought to close the VIX Nov 30 calls for .10
  • Sold to open the VIX Nov 24 calls at .50
New Position – Long the VIX (20.50) Nov 22/24 call spread for even money

VIX options often trade at mid market, at least one leg of a multi-leg order like this.

Rationale: Given the fact that VIX expiration is Wednesday before the open, it makes sense to tighten this spread up, reduce the risk of the index settling below the short put strike that was just recently in the money.  We have dramatically reduced our profit potential in the event of a further spike, but now have no risk.