VIX Term Structure And The Upcoming Rate Hike Provide A Unique VIX (VXX) Opportunity

| About: iPath S&P (VXX)

Summary

Trump rally looks overdone.

Upcoming interest rate decision should lift volatility.

Take advantage of the VIX term structure to trade the upcoming volatility.

Financial writers and Wall Street pundits alike spent the last few months warning a Trump victory in the U.S. presidential election would crush the markets and make the Federal Reserve less likely to raise interest rates. What happened in reality was that the Trump rally made a December increase a near certainty. Currently, the market is pricing about a 93 percent probability of a December rate hike when the Fed meets on December 13-14. However, no one really knows by how much the Fed will raise and what rhetoric it will use; this might cause volatility.

The Trump rally was astonishing, but it seems as it has gotten a bit ahead of itself, and the market is now pricing a rosy future, although we have yet to see any coherent plans or actions by Mr. Trump. Over the long run, one can expect Trump to be Trump, and his unpredictable mouth along with his impulsive actions will lead, in my view, to short market spikes. With that in mind and:

1 The recent market rally that looks overdone

2 Trump's volatile personality and the current transition team turmoil

3 First probable interest rate rise in almost a year...

... one can assume volatility will find itself back above 14 as markets move closer to the December 14 rate hike. This scenario played out many times in the past as pundits start bidding up volatility only a few days before the event itself.

The current VIX index, VXX, price of 12.2 looks too low, one need only to look at the VIX:VXV ratio (the one-month VIX versus the three-month VXV) that dropped from 1.04 to 0.88, which is more than a 10% drop. This kind of drop usually leads to market decline and a rise in volatility as can be seen by the following data:

The current VIX term structure provides a lot of opportunity, I suggest investors build a big position in selling VIX 14 puts expiring on December 14 (currently 0.70 cents), the day of the rate hike, and constantly sell VXX out-of-the-money calls against that position. The logic for the VIX puts is simple. What is the reason to sell the VXX calls? Take a look at the VIX term structure below:

The VIX term structure offers two levels of protection for VXX sellers:

1 The distance between spot VIX and the December contract, which is mainly what VXX is currently holding, stands at 14%.

2 The distance between the December VIX future and the January VIX future that results in a negative roll yield for VXX is currently 10.63% as the VIX rolls over the contracts on a daily basis.

That being said, the level of the VVIX (the volatility of the VIX) warrants to sell only a small amount of VXX calls against the VIX puts and wait for a VIX rise to sell more. Taking advantage of selling weekly calls to maximize theta decay seems wise.

Disclosure: I am/we are long VIX VIA PUTS AND OUT-OF-THE-MONEY SHORT CALLS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Expand
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here