Market Volatility Bulletin: Nowhere, Man

by: The Balance of Trade


The market waits while earnings roll in.

Delving a little deeper into another way to get long VIX.

Why has our options position made money even though ETPs like VXX have lost money over the past several days?

CNBC: Tuesday close

Stocks finished yesterday almost entirely unchanged from Monday's close. The S&P (NYSEARCA:SPY) began the day strong, but fell off quickly, hitting its highs in the first half hour of trading. Though market participants fell noticeably short of the 2300 level, we expect the milestone to continue attracting price in the near future.

The reaction to a few earnings figures served as possible market movers, chief among them was the EPS beat by the Walt Disney Company (NYSE:DIS). You can read a transcript of the earnings call here. That said, the initial drop in DIS shares on the underwhelming revenue figures has dissipated by morning, and the ES futures traded a pretty typical range in its overnight wanderings.

Article Shout-Out

Today we highlight an article published yesterday on SA by Long/Short Investments called " How The Corporate Tax Cut Will Impact Stock Valuations". The author discusses the likelihood of corporate tax reform at some point during the Trump administration, and the possible effects on equity prices and valuations. They analyze four possible tax reform scenarios, estimating market value increases between 6.1% and 14.5% depending on which (if any) of the scenarios play out.

What struck about the piece is that it represents a balanced, well-reasoned, and condensed explanation of how such reform would impact the fundamentals of valuation across a relatively limited spectrum of possibilities. This kind of analysis is so much better than the standard "tax cuts are coming, and they're going to be great!"-style "analysis" we've heard so much of over the past three months or so.

As an aside, we agree with Long/Short's S&P valuation estimate, and that is partially why we take note of analysis suggesting possible further inflation of market prices, despite the already-lofty current multiple.

Thoughts on Volatility

In our article yesterday, we spoke briefly about the middle to back end of the VIX futures curve, pointing out that plenty of action does takes place farther back in the curve. The fun is not all at the spot to front end of the curve. We noted that if you know what you're doing, this can be a "safer" place to take a long VIX position, likely via a spread trade.

The graphic above offers an historical perspective on contango for the four-to-seven month VIX contracts. Though you certainly don't have swings as violent as the one to two month spread, (you can view an illustration depicting that spread here), the contango is not as punishing. Note that the spread does indeed respond to market panics. For instance, observe how the contango suddenly fell in Aug '15, Jan & Feb '16, June '16 with the initial fallout from Brexit, and also Nov '16 with the initial response to Trump's election victory. The quick abatement in contango is exactly when such long-vol spread trades prove profitable.

Current contango for this spread has reached near two-year highs; paradoxically, this provides an attractive opportunity to take a long VIX position without having to take on a roll yield that is so aggressively against you as compared with deadly front-month roll.

While we do prefer to gain VIX-like exposure through ES options, our view is that the middle of the futures curve, long May/short August for example, could be a great way to gain long exposure to the VIX.

Consider that the contango is an aggregate figure: currently 10.48% roll yield for the entire three-month period. That breaks down to 3.43% of roll yield per month, which compares quite favorably against the 11.38% roll yield on the current spot-first month futures pair.

However you decide to play volatility (either long or short), you should weigh your various alternatives before taking a position.

Tracking the Trade*(please read disclosures):

Overnight trading on ES has had a reasonably high range of ten points (2284.25-2291.25). We are currently trading at the low end of that spectrum.

The SPX hovers near its all-time highs as investors await more earnings results. We do believe that for the moment earnings and earnings' guidance are the "lead" catalyst for movement in the indexes.

We are close to wrapping up the trade that we initiated on Monday, Jan 30. To be clear, there is no great reason as to why the trade "should" be wrapped up; we just set a two-week time horizon on the position.

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 clearly still alive for now (as we observed last week for SPY), but the market has over-reached. VIX tried to pick up last week, but it failed early and failed hard. Even at peak nervousness, the index never made it to a thirteen-handle last week. From our perspective the catalysts for increased volatility keep coming, but are summarily disregarded.

We hypothesize here that any meaningful pullback would be instinctively bought up, at least initially. Our downside may be limited due to market knee-jerk reactions built in over the past four years to buy any weakness. Therefore, while we prefer a trade with an inverse exposure to SPY, it is not our primary objective as we illustrate the dynamics of this particular trade.

Last week we "legged into" a long-volatility play whose sensitivity to time is positive rather than negative. In other words, rather than enduring a nasty contango with a long-VIX product, we could get positive exposure to both volatility and time. In keeping with wanting a VIX-like product, we will also set a negative exposure to S&P price movements.

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.

Before we move on, we'll show the current volatility exposures on the two legged trades.

First: the visualization of our two trade legs put on last week:

Attached are current options exposures ("Greeks") to ES price, time, and volatility:

Source: TheBalanceofTrade, Interactive Brokers

Negative exposure to the S&P, positive exposure to volatility, positive exposure to time. Not all that different from long-VIX exposure (at this moment in time: mind you these need to be tended!), but with positive sensitivity to time.

The current price on the first leg (difficult to show because we scaled in and with different strikes) is (approximately) trading with a credit spread of $9.50:

We sold the spreads for $12.50, indicating a $3.00 profit (we did this spread twice).

The second leg - the March April 2150 put spread is currently priced at $9.75. We paid $9.75 on two, so this amounts to a scratch trade.

Total P&L on the trade over the past week is $3.00. This compares favorably against simply having taken a long position in an ETP such as VIX, or having just sold stock.

Tactics (How to Play it): Why this trade has made money so far

From where we sit this trade looks pretty solid. In last week's now-forgotten SPX dip, we scaled in a second time a bit aggressively on the second leg (buying the Mar-Apr 2150 put spread). But that's quite defensible, even though we "should" have held off for a better price.

The important thing is that our exposures are in keeping with where we'd like them to be. That could change at any time of course and require action.

In yesterday's bulletin we proposed a trade modification that involved buying back the two March puts we sold, and selling a single end-of-Feb 2275 put in their stead. We pointed out that we didn't see a compelling reason to do this; just that we wanted to address a trade that could reduce our exposure to SPX price movements.

"Why has this trade been profitable thus far?"

The main catalysts for profit on this trade have been the Feb calls that we sold (one apiece for the 2285 and the 2300 strikes) and the March puts we sold alongside them (one 2150 put and one 2175 put). The other portions of our trade have not done anything special, and if anything have mildly harmed us. That's not uncommon.

The March puts were sold because of our original thesis: the market would initially bounce back on any pullback. Given that prediction, our decision to sell naked puts was justified. With each passing day, the March puts become less and less a problem, and they pair very nicely against the call diagonal that we sold for Feb given our market reaction hypothesis.

The second leg - the March-April 2150 calendar put spread, is where we got most of our "VIX-like" exposure. This trade had the negative sensitivity to movements in SPX, a positive sensitivity to the VIX, and a modest negative exposure to time. As a reminder, this leg has been even-money for us so far: we have neither made nor lost money on this position.

Legging the trade helped with our P&L. If we had immediately traded each of the two legs, our P&L might be lower by perhaps $1.25 or so. Nothing huge, but that accounts for about 40% of the gain on this position. Naturally, it could have gone the other way. Our point of emphasis is that we chose when to roll out our exposures. These are the benefits of trading your view with options over simply going out into the market and buying an ETP like VXX.

In that same vein, we could have chosen different strikes, different expirations on any or all of our options. We feel the particular ones we traded were quite defensible, and those choices come with experience, but our choices were by no stretch perfect or somehow "the only" correct way to take the generalized position. By trading options, you have the control to manage your view in a way that you otherwise cannot.

"How could this trade still go wrong?"

A really big up move in SPX over the next couple days wouldn't be so hot, and the same could be said of a large down move on the underlying. The at-the-money short Feb call is really what is driving our profitability right now. When you short an option, the best scenario is to just hang out and go nowhere. Small moves up or down from here, while perhaps not helpful for our VIX exposure, are great from the standpoint of letting that call (and the March puts we sold for that matter) melt off.

"Any way to change that?"

You could. We proposed a trade mod yesterday that was designed to remove the negative impact of a large and sustained move lower. You can always modify a current position. We just don't believe in overtrading a position. Looking at the straddle prices at the beginning of this section, the market just doesn't see a lot of catalysts for a big move in either direction. Of course this does not mean that the market is "correct"; it just does not see much cause for concern.


We are not making any trades today, and so there are no trade mechanics to consider. Over the next couple days we will be removing our position, and so there will be mechanics to discuss.

Last Thoughts

Hopefully you've gotten a sense that there is another way to play long-volatility other than just buying an ETP like VXX. It doesn't necessarily take all that much work (we report to you daily, but you don't need to modify your own position every day). These kinds of strategies can allow you to tailor your position to your view. That doesn't mean that your view is correct, or that you'll pick all the correct options. But at least they're your choices. No off-the-shelf product can achieve that for you.

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.