Market Volatility Bulletin: Not So Fast VIX!

| About: iPath S&P (VXX)

Summary

While the VIX saw a spike yesterday, the overall level is still quite low.

Implied volatility on S&P options is still trading below 10 for at-the-money exposure for every February expiry.

A more targeted approach for getting long vol.

Most of yesterday's action in S&P (NYSEARCA:SPY) and VIX (NYSEARCA:VXX) took place in the morning, before the inevitable reflexive buying took hold.

VIX told a similar story: It maxed out in the morning (a little earlier than SPX) at 12.86 before calming down to around the low twelve range.

CNBC: Monday's Close

Arguably, the real action took place in the Russell (NYSEARCA:IWM) (by severity) and the Dow (NYSEARCA:DIA) (which lost 20,000). We believe that if the Russell's price action weakens, we may have a decent tell on VIX. For now, it's just something to keep loosely on the radar. We're open to the idea that VIX is ready to move higher, but we need more confirmation for now.

Article Shout-out

Today's shout-out goes to Shareholders Unite, who published a piece yesterday on how to profit from the VIX. Over the years, we've enjoyed the work of these retired Amsterdam professors. They bring a fresh perspective to discussions on the US or global economy, the stock market, wealth disparity and other fascinating topics. They've done quite a bit of work on Seeking Alpha on individual holdings also.

That is why we were interested when we saw them discussing the VIX yesterday. It's not so much the kind of topic that we think of them venturing into. We highlight their piece today for four reasons:

  • They've done a lot of good work over the years and when they write, we read.
  • They provide a fun summary of how strange the mismatch is between markets and the world around us, and how this could or even should unwind.
  • They provide some interesting charts for perspective.
  • We like the fact that they make recommendations for getting long VIX-other- than just going out and buying VXX or similar products.

The authors wrote most the article last Friday when the VIX was printing 10.4. So it was actually a timely recommendation given Monday's early action.

One last point that the authors implicitly make: having some kind of exit. For instance, they don't advocate simply buying a Feb 15-strike call on the VIX and riding it into the sunset. Rather, they suggest taking a position, and if VIX shoots up to say to a level of 12 or 13, consider selling.

Now, VIX futures and options on VIX futures are fairly complicated. We don't agree with the basic tactical structure of Shareholders Unite's recommendations. But we agree that it is a good idea to look at the situation from a variety of angles; they do a good job with that aspect of their analysis.

Thoughts for Volatility Traders

The article by Shareholders Unite emphasizes that while volatility is very low and mean reverting, one might want to give mind to how to trade the fact. We believe that understanding tactics and mechanics are important aspects of "putting on a view". That is what our "Tracking the Trade" segments of these bulletins are all about.

Today, in our "Tracking the Trade" section, we're going to recommend a trade that ultimately gets long S&P volatility, but also doesn't deal with the nasty contango currently embedded into the VIX.

What we found most interesting about yesterday's action in VIX and S&P is how muted VIX really was in the greater scheme of things. Sure, in a matter of twenty-four trading hours, it jumped from 10.30 on Friday at noon to 12.86 by Monday at noon (24.9%). While that's not a bad offing, the markets have since settled in. The S&P managed a bounce from a low of 2,268 back to 2,280, a level which corresponded to an all-time high just on January 6th.

The overall message of the market is that while we've seen some downside excitement, it is not (yet) expected to last. Implied vol on at-the-money options for every expiration in February is still stuck with a nine-handle.

That doesn't necessarily mean that the markets are correct. But we always start any analysis by just listening to what the VIX term structure and/or ES implied vols are saying. And for now, they're suggesting that we shouldn't get too excited yet.

Let's have a look at VIX contango over the last few months.

The blue line charts the total level of contango paid for taking a long position in a one-month VIX futures contract offset by a short position in a two-month VIX futures contract. The green line tells a similar story, but for spot against a one-month contract.

Today's levels of contango are not out of line with what we've seen over the last several months. In other words, while the overall level of the VIX may have been quite low, the contango paid has been fairly typical.

We do see that the green line darted lower recently, but the blue line has not done much. We're seeing the overall trend contango falling, which signifies that perhaps markets are stirring from their slumber, with the short end of VIX responding first.

Still, we may yet have a long way to go before long-VIX fattens anyone's purse!

Tracking the Trade*(please read disclosures):

As we write this near market open, ES trades at 2,271; overnight trading range was 2,268-2,276.50. This morning's open is not so different so far.

Yesterday, we began discussion on a new trade. We brought up the idea of legging into the trade: not putting the entirety of a trade on all at once.

Remember, pricing can change rapidly between the time we write this and the time you read it. The goal here is for you to have an educational experience that can expand your skill set and perspective.

Thesis (Strategy):

Buy-the-Dip is still alive for now, but the market has over-reached. VIX could likely pick up soon, but it may yet be a couple weeks. While yesterday's action was encouraging, we still don't buy that we have a real VIX spike on our hands yet. We hypothesize here that any meaningful pullback would be instinctively bought up, at least initially. Therefore, our downside may be limited due to market knee-jerk reactions built in over the past four years to buy any weakness.

We'd like to "leg into" a long-volatility play whose sensitivity to time is positive rather than negative. In other words, rather than enduring a nasty contango, we could get positive exposure to both volatility and time.

For those who do not know, "legging into a trade" refers to the popular practice of gradually building into the overall position rather than trading all the desired options legs at once.

Tactics (How to Play it)

We'll set a trade that we can watch play out over the next couple weeks, so that we can examine its features and behavior in bite-sized pieces.

From yesterday's bulletin:

As an initial position that we'd like to build into, we recommend the following:

Sell the Feb 2300 call against the end-of-Feb 2320 call for a modest credit. Pair it with a sale of the Mar 2175 put

Below is what the P&L exposure looks like today (solid line) and at the Feb expiration (dotted line).

"What do you do now that we're farther from the max profit point of 2,300?"

The dotted line represents the P&L profile at the time of expiry for our earliest-maturing option. In this case, that is the Feb 2300 call.

One reason we legged the trade is so that we can deal with this aspect over time. We're not quite ready yet for the second leg, but we may recommend an additional position to the first spread: making a trade similar to the one made yesterday, but with modestly different exposures.

The concern on getting farther from the "max profit" strike is legitimate. It matters a great deal how jittery you are (you shouldn't be), and it also may matter to you how likely you feel it is that we'll do a retest of the highs. In other words, as always there is some discretion here on how to proceed.

For now, we'll stick to our plan from yesterday of adding a spread here, but with lower strikes for all legs.

  • Short the Feb2285 Call vs. Long the end-of-Feb 2300Call
  • Short the Mar2150 Put

"Why did you switch the strike prices?"

We're layering into the first leg of this trade a second time. This is not dissimilar to dollar-cost averaging in. Given that the market is lower, however, and that we have yet to initiate additional legs to the trade, we want to move our strikes in accordance with yesterday's price action.

In fact, you could make the case that we should move the Feb calls lower to the money on this second layer. That would pay more theta (time decay) and give the option a better overall vega profile (more volatility).

We have found over the last several months that the S&P never hesitates to find a reason, no matter how tenuous, to rally. We believe that this is index traders' first instinct (buy any weakness), and so we don't want to get too aggressive on readjusting strikes. We believe this modification to be reasonable.

Mechanics (Entering the position a second time)

When entering an options position, making use of limit orders is frequently a good idea. This is especially true when:

  • you have no dire need to get filled on an order
  • you are filling multiple orders where the early fills are important but the duplicate fills not so much so. This is a duplicate fill.

Say, for example, you really want to reduce risk. Well then, you cannot be overly picky on price. Take market, or close to market.

Or suppose that you want to trade five of a particular position. It may pay to layer in to your position at increasingly attractive prices.

So you're not so picky on the first order, and you set stingier and stingier limits as you add to your desired total. Since that is our position today, we ought to hold out for a little better of a fill than we otherwise would.

Because we are opening and legging into this trade a second time, we can wait to get filled at a more attractive price: say $12.00.

For the purposes of this sim trade, we'll break the spread into two pieces. The diagonal:

And then, the individual March put sale:

This is a credit spread - a spread that you get paid upfront to make. You might expect to get filled on the overall trade at approximately $12.00. With the 50x multiplier that ES carries, this amounts to $600 per spread. IB would charge you $4.23 in commission to make this trade.

By making this second trade, we've essentially just traded the first portion of our strategy a second time. That's important, and we'll show you why in the table below.

Resulting Greeks

Remember this is basically the second time we've traded this spread. The results for the table below are for both trades, not just today's.

Source: Interactive Brokers

Note that the current spread carries a positive exposure to time (it "collects theta") and a negative exposure to implied volatility (negative vega). The two spreads we've sold are picking up $.96 total in theta, with a -3.53x exposure to vega.

The vega exposure means that if implied vols on each of the individual options we've traded were to rise by one vol point (think VIX higher by one handle), the spread would move against us $3.53.

Worse yet, the vega exposure gets worse as the market goes lower! To see this, look at the current vega exposure (Row5) for the various columns.

We'll need to add a leg or two to punch the vega higher (that was after all the goal of the combined trade: receive theta while having positive exposure to volatility). That will be covered over the next couple sessions.

For now, suffice it to say that this trade does not yet carry the positive vega exposure we're ultimately seeking. We're entering a little aggressive on our positive theta as we leg the trade, at the expense what is arguably an overly aggressive vega.

If that makes you uncomfortable, remember that these trades are to motivate the way you think about strategy, tactics, and mechanics.

It is highly unlikely that you would make identical choices to what we're making. Sometimes the positions we don't like push our thinking the hardest. Disagree in the comments section if you don't like this legging process (or even the way that we're legging).

Last Thoughts

The options market is telling us to stay calm. Again, vol is still quite cheap for all of February, and much of March. There are a variety of defensible ways to play this, but trading "jumpy" isn't one of them.

We believe that legging into the position with a call diagonal that's likely to favor the call we sold over the call we bought warrants selling the further down March put. In this sense, the March put is acting as a counterbalance: something to profit from if the SPX turns back around to retest the highs.

Hopefully, by continuing to read, you will learn some of the ideas behind the strategies, tactics, and mechanics. We hope you come to view these bulletins as a valuable resource that advances the way you understand markets.

Please consider following us!

What do you think?

As our ongoing parting note, our goal in writing here is never to get you to agree with us on strategy (in this particular case: sell time, leg into a long vol position). In fact, we love to hear comments from people with different views! Our goal is definitely not to suggest that you ought to put on these specific trades (please read our profile). Rather, the ongoing goal is to walk readers who wish to expand their current set of tools by following trades that could potentially match their own market outlook. Please follow us to track this trade and commentary, and thank you for reading!

Disclosure: I am/we are short SPY.

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.

Additional disclosure: We actively trade the FX and futures markets, potentially taking multiple positions on any given day, both long and short. It is our belief that the S&P 500 is meaningfully overvalued. As such, we typically carry a net short position using ES options and futures. We want to emphasise that these "trades" are for educational purposes, to demonstrate how to reasonably analyze, enter, adjust or modify a position. These are NOT actual trade recommendations.

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