Many short term traders would like to take a stand on volatility, i.e. get long the VIX at let's say 16 or perhaps get short the VIX at 22. But let's face it, speculating on the direction of volatility is really no different than speculating on the direction of a stock. Traders spend hours researching the fundamentals, maybe some technical analysis, some investor sentiment, etc.They then put on the trade and watch as it goes against them.
Trying to forecast the direction of the VIX or volatility is challenging and executing a long or short in the VIX can be challenging as well. As most VIX traders know, the underlying index is simply a metric and cannot be purchased as such. Some of the ways traders can get long the VIX, for example, is through the purchase of VIX Call Options and/or purchasing the futures on the VIX. However, purchasing VIX Calls usually entails paying the premiums. VIX Futures trade at a discount or a premium to the index; and currently, the VIX Futures are in contango to the cash price presenting all kinds of headaches for the trader/investor who would like to be long and mimic the spot price. Yes, there are some tracking ETF's and ETN's that try to represent the index but they too, pose the same challenges as VIX Calls and VIX Futures in that these products track the index indirectly through the futures contracts.
The pseudo correlation between these products can provide professional traders with some quasi-arbitrage opportunities that exist between the ETF's, ETN's , futures and options. As a trader, I never seemed to get the direction of a stock right and I had just as bad of fortune when picking the direction of volatility. But by parsing through some of the aforementioned products I may be able to identify some delta-neutral or as close to delta-neutral arbitrage opportunities as possible with a trading edge.
I do not know where volatility will be trading next week, next month or next year, however; I do know that VIX Futures will converge with VIX Cash over time. Having said that, I would like to present a trade that includes the VXX vs. VIX Options. I did mention earlier that the VIX Futures are in contango and as such, I would like to sell and capture the options premiums found in the VIX Forward Months Options. For example, the VIX February Options are reflecting a VIX Futures of approximately 22. To hedge against these options I would get long VXX. The VXX has been a disaster for traders and investors alike who have been on the long side of this ETN., mostly because of the contango curve that has been in place for some time now. As a short term trade, (one day to 4 months) this particular ETN will be a suitable hedge against the VIX Options.
The VXX is an ETN that tracks the VIX based upon the weight of the first two VIX Futures months. The contango curve, the rolling expenses incurred by selling and purchasing the contracts to reflect the parallelism of the price's first two futures months has been a drag on the ETN. . However, for a spike in volatility and/or a VIX backwardation curve this is the product you would want to own.
Here is an example of a trade where I would get long VXX and short the VIX February 20 Calls:
|Long VXX||Sell 3 VIX Feb20Calls @ $4||Break-Even VXX|
The sample trade above is devised to capture the high premiums in the forward months in contango. Therefore, three likely scenarios:
- Scenario One: A spike in volatility reflected by an upward price move in the first two months of the VIX Futures. This is the best case scenario where the trade could probably be taken off for quick handsome profit instead of letting the time premium on the VIX Options decay.
- Scenario Two: A subdued VIX with no further increase in the contango curve or a leveling off of the contango curve. The VXX should languish however the calls sold on the VIX would lower the VXX breakeven to 23.
- Scenario Three: The deepening of the contango curve could blow this trade up. For example, the first two months VIX Futures remain at 15 or grind lower while February VIX Futures move higher or explode higher.
Given the scenarios above I like my chances, but I would keep this trade on a short leash as I do with all quasi-correlated products. If you are a seasoned trader, there are many variations to this trade. You may want to consider selling March or January VIX Options and you may want to consider moving up or lowering the option strikes. Moreover you may want to consider getting long VXX synthetically or with an imperfect synthetic. Either way I believe the trade has a decent edge in it without taking an opinion in the direction of the VIX.
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.