Following up on the points Dan made in today’s MorningWord earlier about the unlikelihood of vol sustaining these historically low levels when the market either attempts a breakout or fails, we wanted to follow with one of our favorite VIX futures trade structures. We’re going to focus on March in this post as the March 22nd expiration catches the next Fed meeting (March 15th, currently Fed Fund futures are pricing a 34% chance of an interest rate hike). But even if the Fed doesn’t hike in March we should be getting a better sense of their path for the rest of the year. And on Yellen’s testimony today Fed fund futures ticked up a little bit as she seemed to at least add a little uncertainty to what the market was pricing in. (Read more on this from Peter Boockvar here)
Either way, it’s unlikely we see VIX pinned near 11 for much longer.
So What’s the Trade?
There’s a pretty easily defined risk/reward profile in the VIX futures right now, it’s just a matter of your time horizon. With the spot VIX at 11.10 and the March VIX futures at 12.90 we can sell a put spread in March that is only at risk if the SPX goes sideways for the next month. We can use that put spread sale to finance the purchase of a slightly out of the money call spread with a great asymmetrical risk reward:
VIX (11.10) Buy March 22nd Risk Reversal (sell Mar22nd 12.50/10.50 put spread to buy Mar22nd 14 /24 call spread for Even Money
- Sell to open 1 March 12.5 put at .85
- Buy to open 1 March 10.50 put for 5 cents
and
- Buy to open 1 March 14 call for 1.00
- Sell to open 1 March 24 call at .20
Break-Even on March 22nd VIX Expiration:
- Profits: up to 10 between 14 and 24 with max gain of 10 at or above 24
- Losses: up to 2 between 12.50 and 10.50, max loss of 2 at 10.50 or lower but capped there.
Rationale – By selling the March 12.5/10.5 put spread we’re defining our risk to $2 if the VIX were to settle at 10.50 or below in March. We can use those proceeds to buy a call spread that is 10 dollars wide. The spot VIX is now near 11, already in the money vs our put spread sale, but the March futures (of which these options are priced off of) is closer to 13. The 14/24 call spread is where this risk reversal makes money. It wouldn’t take much of a spike in the VIX to put that call spread in play. Any VIX March settlement between 12.5 and 14 and there’s nothing down on this trade. It will have been a free look. But it can be worth up to $10 on a spike above 14 up to 24. The best way to think of this from a risk perspective is you’re basically betting the VIX goes higher from these historically low levels over the next month and change. If we don’t see an uptick in vol, you’re risking up to $2 if the VIX settles below 12.50 on March 22nd expiration. Any move higher in the VIX between now and then and this will be quickly profitable. Further declines in the VIX futures in March and it will lose money mark to market, but it’s unlikely to lose all $2 risked anytime soon, if at all.