Putting The Range-Bound VIX Into Perspective

Includes: SPY, TVIX, VXX
by: LoneStarQuant

As SPY continues to break record highs, it is natural to see the VIX taper down, but how low can the VIX go and for how long? This article is designed to put the current move of the VIX into perspective and to explain high probability ways to profit from abnormally low levels of implied volatility. Here is a chart of the VIX and VXX for the past year, and as we can see below, VXX is highly correlated to the VIX but has a downward trend. The VIX of course, measures the implied volatility for the S&P 500 for the front month options contracts. In other words, the VIX measures the cost of insuring your portfolio and it's currently really low.

The VIX hit an intraday low of 12.24, a multi-year low level for the index. In order to put this movement into perspective, I have collected five years of daily data on the VIX's adjusted closing values and produced a cumulative density function (CDF) to gain insight as to the probability of the VIX being at or below a particular level.

What does this mean to an investor? Here is an easily identifiable opportunity to both insure your portfolio and make an aggressive trade without taking much risk. Insurance is cheaper than it has been in years.

The above graphic can be immensely useful when comparing relative levels of the VIX. Based on the above data we can ask, how often does the VIX close below 14.25? Only in about 2% of days in the past five years has the VIX closed at or below 14.25. This statistic can easily be used to your advantage. It should be quite obvious that taking a long position is likely to pay off in a relatively short amount of time and rather substantially considering how quickly the VIX jumps.

A statistical edge is critical to taking advantage of these levels on the VIX, which is also why it's important not to lose that edge by holding inefficient ETFs like VXX or TVIX for long periods of time. Going long is never effective because such ETFs suffer from contango and asymptotically approach zero. The only time these ETFs are useful is when you would short the VIX at high levels, in which case, you could short sell shares of VXX (if your broker can get their hands on any shares).

The most effective approach to gaining long exposure to the VIX is to stay on the sell-side of VIX puts. Right now is a great time to sell at-the-money put options on the VIX in May (or make it a credit spread by purchasing the 10 strike) and close the position as soon as there is a spike in the VIX. This type of option play keeps time on your side, has a great return on investment, and has an extremely high likelihood of success. If you are feeling aggressive and know that low volatility is not here to stay, step into VXX if you want to hedge your portfolio for a few weeks.

The best part about being long the VIX or VXX at these low levels is that we know the VIX cannot go lower than 9 or 10 and we also know the VIX is mean reverting, so on average, it is resting around 18.

Given our macro environment and global uncertainty, sustainably low levels on the VIX are not likely here to stay. We are in rare territory, so take advantage of mean-reversion in the VIX. This can be done several ways, either being long VXX or even better, selling ATM put options expiring in May on the VIX. This trade keeps statistics and time on your side. Stay smart and take advantage of the rare climate.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , , Technical Analysis
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