In February we looked at the historically low level of the VIX and detailed a long vol trade isolating the March FOMC meeting. Here was the original trade and rationale, from Feb 14th:
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
- Buy to open 1 March 14 call for 1.00
- Sell to open 1 March 24 call at .20
The VIX hasn’t done much in the meantime and the broader market is slightly higher. Gains and losses mark to market in this trade idea to this point have been small, with it worth about .75 profit at one point, and as much as a .60 loss more recently. Today, with the VIX about 12.50 it could be closed for about a .25 loss.
The potential reward on this trade is a sustained selloff in the market. There’s very little mystery left going into the FOMC announcement tomorrow as to whether they will raise rates. The market is assuming that and it is why there hasn’t been much realized market volatility nor implied volatility spike into the meeting. But that means the big risk to this trade is we get nothing unexpected from the Fed tomorrow, the market rallies, the VIX gets crushed to below 11. That is a real risk. On the flip side, there is still opportunity as March expiration is a week away and it wouldn’t take much for the VIX to be above 14 if the market sold off following the meeting. But what is clear is any spike would not be massive as there seem to be buyers lurking on most down days.
So for trade management purposes, there are a couple of things that can be done. The entire trade can be closed here for a small loss, removing all risk into the meeting of the VIX going significantly below 12.50 in the next week. Remember, the risk on this trade is $2 if the VIX settles at 10.50 or below. If closed today the trade idea ends up being about a .25 or .30 loss. Taking that loss would entail closing the entire call spread and the 12.5 puts, but leaving the 10.5 long put (which in a weird way would be a lotto ticket in the other direction that could actually make money if the VIX got smoked).
The other possibility for those that still want exposure for a vol spike in the next week, is to close the 12.5 put and take off all downside risk. That would cost .60. The issue with that strategy is your breakeven would then become 14.60 with only a week remaining and the VIX currently more than $2 away from that breakeven. But it’s an option for those willing to risk .60 rather than 2.00 for that opportunity. (and in this scenario you also keep the 10.5 put as a lotto ticket the other way, it’s not unfathomable that that could be worth money following the meeting if the market rallies sharply.)
Overall, we consider this trade idea small risk for big reward and love it as a strategy to get long vol when the VIX is low. But we also like to isolate events, and that event is quickly approaching with little mystery. Even with the VIX low near 12.5, there is still downside risk because there’s probably about $1 of FOMC premium in that, that will go away tomorrow if the market is unchanged or higher and the VIX would likely be 11.50 or lower in that scenario. That wouldn’t not happen if the market is down sharply after the meeting. So basically this is a market short at this point, with one week remaining and from a risk reward standpoint should be treated as so.
We’ll start to look at similar structures out a few months as the opportunity remains for just one market correction to pay off with a fairly large VIX spike from such low levels.