CBOE Volatility Index Bull Put Spread On The VXX

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 |  Includes: VXX
by: Kenneth Roberts

The VIX is widely quoted and is referred to as the "fear index." The VIX is a measure of the implied volatility of options on the S&P 500 index. There are options and futures on the VIX and ETFs that attempt to mirror the VIX in some way. One of the most liquid ETFs that follow the VIX is the VXX. The VXX has weekly and monthly options that trade in penny pilot increments and has very high liquidity. The VXX does not attempt to track the spot VIX, it attempts to track the short-term futures on the VIX.

The VIX has a seasonal tendency to bottom in July and December. Seasonally, September can be the worst month for stock returns. The VIX normally moves inverse to the stock market. If the market declines, the VIX should rise.

With the VXX at its annual lows right now, a bull put spread for the October expiration cycle has some favorable characteristics. The October 20, 11 by 10 bull put spread can be sold for an initial credit of $0.47 cents. If you were to use a 100 contract position, the maximum gain would be $4,700 and the worst case maximum loss would be $5,300. There is a 57.12% probability that the VXX will be above 11 on the October 20 expiration date. The theoretical profit is $151.71. So, the mathematical odds are favorable.

Dr. Rob Engle of NYU won a Nobel prize for his work in volatility forecasting. He developed the GARCH model, which stands for generalized conditional heteroskedasticity. Today in addition to GARCH, there are also several variants known as AGARCH, EGARCH, GJRGARCH, and more. At the present time, all of the GARCH volatility forecasting models are projecting a rise in volatility for the S&P 500 over the coming months.

This trade is favorable for several reasons; 1- mathematical probability, 2- Seasonal market tendencies and 3- GARCH volatility forecasts.

(click to enlarge)VIX Daily with SV/IV ratio and standard deviations.Click to enlarge

(click to enlarge)PL Graph for VXX Oct 11 X 10 Bull Put SpreadClick to enlarge

(click to enlarge)VXX DailyClick to enlarge

Disclosure: I am long VXX. 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.