Volatility Players: Mind The Gap

Includes: TVIX, UVXY, VXX, XIV
by: Josh Krause

With many long volatility products now near 52-week lows, I am seeing more and more people starting to accumulate shares in VXX, UVXY and TVIX or initiating shorts in XIV. Most of the stated justifications resemble some sort of bet or hedge that Bernanke will roil the markets on Wednesday after the FOMC meeting concludes, and there is a good chance that is a solid bet.

With spot VIX hitting 17.36 intraday today, the market is marginally complacent. Using the calculation for expected move in the next 30 days from my previous article of 17.36 / 3.464, the market is pricing in a 5% move in either direction in the near term.

The spot VIX price is about halfway between the normal range of 15 to 20 during "crisis" times, and starting a position here would be a good starting place for those with sufficient fortitude. However, anyone expecting to hold any of these products longer than a few days has to understand that only the nimble can successfully trade volatility products. The reason, as always with volatility, lies in the future(s market).

Not as Calm as It Appears

Even though spot VIX is not sending warning bells at 18.31, the futures market is still pricing in a large move. With July futures at 22.00 and August setting at 23.80, the market is going to have be extremely volatile in the next 30 days for long volatility players to be rewarded.

Let's run a few scenarios and see what the crystal ball says.

1. Bernanke delivers what the markets ordered: Volatility flat to down.

With spot at 18 and front month futures at 22, anyone holding VXX would expect a loss of up to 18% if volatility does not spike significantly. Double that for UVXY/TVIX and we just took more than a third out of your position. Mind you, this is if volatility just stays where it is, if spot VIX falls significantly, the damage will be correspondingly worse.

2. Bernanke slightly disappoints the market: Volatility flat to up.

Again, with the 15 to 20 range in mind, we could see volatility run up from here and peak above 20 if there is no materially imminent crisis. Anyone holding VXX could see 9% loss as front month futures head to 20 from here and spot reenters the normal range.

3. Bernanke drops the ball: Volatility up to moonshot.

Of course, the scenario will work out well for anyone who is long any of the volatility products. However, the lesson from last year still shows that one needs to remain nimble even with a spiking VIX. Any significant spike could lead to backwardation in the VIX futures market, and if it maintains over multiple months could lead to outsized gains.

Trading Plan

I would recommend those attempting to capture a volatility spike from Bernanke to have set stop losses and abide by them. The candles that were set today seem bullish for volatility plays but the gap that exists could already be pricing a spike in to the futures. Expecting additional strength in VIX leading up to the closing of the FOMC meeting, one could go long UVXY here at 12.08 and just sell before 12:30 to capture the easy money.

Beyond that would depend on the market reaction to Bernanke's Fed and I would expect the move to play itself out quickly. Just remember that the gap in futures vs. spot is significant and must be acknowledged and respected.

The ~$4 gap between spot VIX and front month futures leaves me with a lot of pause for recommending any long volatility plays for more than just tomorrow. Many were burned under similar circumstances in March with the spot/front month gap closure taking large chunks out of anyone holding VXX, TVIX and UVXY.

Any longer-term plays should be postponed until VIX is closer to the extremes and the gap in futures is less concerning. If VIX does head down to 16 and front month futures to 18, shorting XIV is pretty close to a no-brainer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.