VIX on Vapors

by CC September 8, 2016 12:14 pm • Trade Ideas

Earlier, Dan reiterated a point we’ve been making here on the site, in that vol is historically cheap, based on historically low actual volatility through July and August. As JP Morgan’s Marko Kolanovic pointed out on Fast Money last night, there is a snowball effect during low periods of volatility as gamma reached historic levels (meaning a pinning effect happens where the market goes higher and there are shares to be sold, and market goes lower and there are shares to be bought. You could have watched this effect intra-day over the past few weeks where most morning market gaps higher and lower faded by day end. (In fact you can see this action today, with the market down at its lows around 10am and now unchanged a little later once buyers stepped in):


I wrote about this effect back in March, in relation to individual stock volatility, after implied volatility got crushed after the spike in Jan/Feb:

This is a bit wonky and isn’t a rule of thumb that can be used for all events, but it’s something to be aware of after big spikes followed by big declines in the VIX. That vol hangover may be over pricing individual stock movement and and can have a snowball effect on declining option prices until it clears from the market through option expirations. You’ll hear a lot of people say “Buy Volatility” once it’s come in after a big spike, but you want to be as patient as possible so you can wait out that hangover. What are the signs to look for? A break of the trend of daily moves of less than 1% in the market that we’ve seen recently. As well as a sustained move to the downside that lasts more than 1 day and isn’t immediately bought the next day.

Side note: the opposite is true of events in the middle of a broader market volatility spike as options may not be properly pricing individual stock movement with all the short gamma in the market and those moves can accelerate through lines with heavy short interest as stocks need to be chased by market makers to stay delta neutral.

I wrote that in the midst of the vol hangover in March, when the VIX went from over 30 in February to the mid teens. We saw something similar this Summer when the VIX spiked to the mid 20’s to be followed by its current dirt nap near 12:

1 year VIX from LiveVol Pro

So the same lesson holds true here. After the spike in January, it took nearly 4 months for that gamma to clear and the market to be shook up in June. These periods of low volatility can be deadly for those long premium and patience is a virtue as the longer you wait to slap on some hedges or stock alternatives the lower vol tends to be.

We’re at one of those possible points. The Summer is over, Fall generally gets market participants antennas up and this Fall we have a few big known events in FOMC meetings and the U.S. Election. But we don’t want to to run out and buy vol blindly.

So What’s the Trade?  

We like the idea of looking out a few months and establishing a position in the VIX options where a large spike could be very profitable, whereas a continuation of this trend lasting into year end risks just a little and has a high likelihood of ending up with no losses or gains. In other words, a good things for those that would like to profit from a spike in volatility against possible losses in stocks if the market takes a downturn. (this is not a perfect hedge against a long portfolio, but it is a trade that would be profitable

*VIX ($12.25) Sell the Nov 15 put to buy the Nov 20/29 call spread, this is what we call a call spread risk reversal, and could be executed for even money
  • Sell 1 Nov 15 put at 1.00
  • Buy 1 Nov 20 call for 1.70
  • Sell 1 Nov 29 call at .70

Rationale and break-evens: OK, but first let’s talk about the difference between the spot VIX and the VIX futures for a second. Right now the spot VIX is 12.25 (used as reference on the above trade, you cannot trade the spot VIX). But that is not what the options in the VIX are priced on. They are priced on the futures for that expiration. So right now, Nov VIX futures are 17.20. This call spread risk reversal is based off of the futures being 17.20. And that is why the sale of the 15 put is intrinsically valuing the VIX much higher than it is now. It is assuming that the spot VIX will see spikes between now and November expiration and won’t continue to flatline around 12. That’s a realistic assumption.

The risk to this trade is that the VIX does just that. And that would mean the futures in November drift lower. So the real risk of this trade is a VIX below 15 in November. In that case the sale of the 15 put is risking a few dollars. If the VIX settles at 13 in November, the trade would lose $2. That is entirely possible, but the VIX doesn’t go to zero, so the risk of losing money on that put on settlement is limited to a few dollars. But the good thing about this trade is the most likely scenario is that the VIX settles somewhere between 15 and 20, in which case there would be no loss on expiration. But if there is any bout of downward volatility between now and November (somewhat likely) and this trade could be profitable with any VIX move towards or above 20. And in the case of a more serious market correction between now and November expiration (not as likely, but always possible) then this trade is there with the chance of making up to 9 if the VIX is at or above 29 on November expiration.

One of the first steps in trade management on a volatility spike would be to cover the short put (taking off the risk as well as the margin requirement, but let’s not get ahead of ourselves.