Volatility Players: Draghi Saved The Day, Again!

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

After exciting the markets last Thursday, ECB president Draghi went a step further and recruited other EU officials to join the call to save the union at all costs on Friday. This took us to new highs in the SPY for the month, and should provide support for the markets as they wait for the final word this Thursday. Volatility collapsed back below 17, and things were right in the world again.

Looking at this week, we have Ben Bernanke and the US Super Bankers set to meet on Tuesday, with final results posted on Wednesday at 12:30 p.m. ET. Not to be outdone, Draghi will have the opportunity to wow the markets at the ECB meeting on Thursday. This one-two punch could either take the markets to the stratosphere with the promise of more free money, or take us down to the mat on a disappointment. Combine it with Non-Farm Payrolls on Friday, and we could be looking at the knockout that so many have be warning about.

Wild Things

Before we go into any of that, let's take a look at the short term structure in VIX (as of 2:30 p.m. ET today):

Spot VIX: 17.98

Aug Futures: 19.20

Sep Futures: 20.90

With a spot/front month gap at 6.8%, and a front/next gap at 8.9%, we are back to a relatively flat term structure and a daily roll cost due to Contango around 0.35%. That is to be expected, as the headline risk is so great in both directions that the futures are tightening up in front of a big move.

Think of it as a coiling spring. Since near term there is some volatility due to headlines, we are seeing spot VIX rising, but since we can't make a hard guess on the future, you aren't seeing much action in the futures market. Once a direction is determined from the resolution of this week's events, we should see a quick move in the futures either way.

What's The Play?

As always, we look for a good play to make on volatility. To be honest, the only play I would think about making would be long volatility in front of the FOMC announcement on Wednesday. Sadly, it appears we may have already priced much of that in with today's action as we have move back to spot VIX at 18.

Anything past 12:30 p.m. on Wednesday is a crap shoot. If there is disappointment by Ben, it could easily be turned on its ear by Draghi and the ECB the next day. If we get disappointment by all three (FOMC, ECB, and NFP), I would expect large moves in volatility products (VXX, UVXY, TVIX) and the potential for a revisit to Backwardation, ala summer 2011.

While my gut says that Bernanke will likely disappoint the markets, I have an equal feeling that Draghi will have to do something rather spectacular on Thursday. Europe is staring down the abyss with Spain still at near record yields. Unless Merkel is completely nuts, she is going to have to relent and allow Draghi to fire up the printers. Is it unsustainable? Is it short sighted? Is it likely against the EU charter? Yes to all three, but that has not stopped them in the past when implementing such measures.

Europe is going to continue to flare up over and over again due to its incomplete fiscal union, and that should provide volatility players ample opportunities to profit in the future.

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