Market Volatility Bulletin: Something's Not Right

by: The Balance of Trade


VIX keeps catching a bid while indexes tear to new highs; a reader chimes in with a thought.

VIX term structure during the last debt ceiling debacle.

Closing down our profitable ES trade.

CNBC: 8:30 EST

It's red across the board in both the US overnight and European sessions, as concerns from the upcoming French presidential election begin weighing on the markets. Most recent polls have the far-right candidate Marine Le Pen leading through the first-round of voting, to take place April 23. If no candidate achieves a majority of votes, a runoff round of voting will take place May 7 between the top two candidates.

The VIX is up over 5% before the opening bell, slated to open well above the 12 level we've kept tabs on the last few days.

CNBC: 8:30 EST

The Dow Jones Industrial Average lead the bullish charge again on Thursday, closing at record levels for a 10 th straight day. Johnson & Johnson (NYSE:JNJ) contributed the most to gains, as the markets absorbed statements from Treasury Secretary Steven Mnuchin regarding tax reform. Though light on details, his statements did attempt to give a firm timeline; Mnuchin hopes for significant reform before Congress breaks for their August recess.

CNBC: Thursday Close

Though the S&P gapped up to record highs on yesterday's open, it aggressively sold off for the first two hours of the U.S. session. Once market participants breached Wednesday lows, however, buyers swarmed into the market and drove price back towards the highs to close the day in the green. Over much of the past three weeks, we've noticed a strong buying presence heading into the close of the U.S. market session.

Yesterday, one of our readers pointed out the following trade that has seemed to work quite well over the past several weeks:

Good observation Chaffey! In all seriousness, traders can and do pick up on cues that in and of themselves are not all that meaningful. These patterns become self-fulfilling until they burn out. Way to point out the pattern!

As we've seen frequently from the VIX over the last week, the market's "fear gauge" was once again unable to sustain movement above the 12 area. After breaking sharply to the upside early in the session, the VIX topped out at 12.46 before settling back down to 11.71 to finish out the day. Today we had yet another attempt, and as this goes to publication, it appears that VIX is settling down once more to 12.13.

Article Shout-Out

Today we highlight a brief article published yesterday by Elazar Advisors, LLC. We highly recommend our readers take a look, as it takes all of three minutes to get through. The piece is titled "Trump And The Debt Ceiling (March 15)."

Elazar sets the stage for the upcoming debt ceiling deadline by offering an overview of our last three debt ceiling crises, and taking note of the markets' reaction to each event. The author first notes the 27-day government shutdown, which took place in 1995-96 when Congress and President Clinton were unable to reach a budget agreement.

In the next budget event, which took place in July of 2011, markets sold off significantly. Though Congress was able to come to an agreement to raise the debt ceiling, the U.S. was hit with its first ever S&P ratings downgrade. The chart below, sourced from Macrotrends, shows markets during this period.

The author also notes the year-long budget battle in 2013, after the debt ceiling was reached at the end of 2012. By October 2013, Congress suspended the debt ceiling after markets had received substantial volatility throughout most of that year. Elazar displays the chart below to demonstrate the volatility surrounding these particular budget events.

Elazar wraps the article up by looking at a quote from Mick Mulvaney, President Trump's director of the Office of Management and Budget. Mulvaney believes that the debt ceiling should likely not be raised, and while a U.S. default would have significant consequences for the worldwide economy, he does not believe that the breaching of the debt ceiling would automatically yield that result.

Thoughts on Volatility

In a continuation from both yesterday's bulletin, as well as the article referenced above, we examine VIX term structures that were seen amid the past U.S. budget events. Like yesterday, we do not bring up these past scenarios as firm expectations for future VIX term structure, only as a reminder of the possibilities given a similar situation in the future.

As the reader will note from the chart below, current VIX term structure remains largely unchanged, though overnight we've seen a modest up move in pricing throughout the entirety of the curve.

Since VIX data was not disseminated in its current state before 2003, we will begin with a look at the term structure surrounding the July 2011 debt crisis.

Taken from the days immediately following the final-hour save by Congress, the chart above shows the contorted shape that the term structure can assume even if a debt limit is not actually breached.

Observe that the VIX term structure here is quite similar to the structure surrounding the Brexit news during the middle of last year. We'll note that critically, this is the term structure before news of an S&P ratings downgrade hit the markets, with front-month futures already elevated to above all actively traded deferred-month contracts. During this period, spot VIX reached levels as high as 45 before settling back down.

Though the debt limit issues that plagued the markets in 2013 could be seen coming up on the horizon for nearly a year, the reaction that the VIX term structure displayed was quite subdued, especially as a comparison to the crisis of 2011. Specifically, the chart above, taken from right before the debt ceiling was suspended until February of the following year, does exhibit a higher degree of caution from investors who were positioned at the front-end of the term structure.

We invite our readers to keep in mind the potential for VIX term structure to weigh in many differing factors. As such, during times of uncertainty, such as the looming debt ceiling date, the term structure can take on, and even maintain some very atypical shapes. Like we stated yesterday, beware the conditioning of the past several years that VIX term structure always needs to quickly return to "normal" in a rapid and orderly manner.

"Organic vol" -- the kind found on the underlying S&P as opposed to VIX -- is up across the board: particularly at the back end. Mind you, these are not massive changes. However, we would classify them as irregular given the relentless moves higher in the indexes. Yesterday's drop in the Russell may indicate cause for concern. Any way you slice it, vol is finally catching a bid, and more so at the long end. The May at-the-money straddle is up about 8% in price from yesterday.

All that said, we are seeing organic vol pick up across the board. Bear in mind that these are still very low levels: May at 12.5 IV is hardly a "high price of vol."

Tracking the Trade*

Last week we began a new trade to follow through to tomorrow, when we decided to close out. Our trade specifications were as follows:

  • Trade horizon: Friday, Feb. 24
  • Instrument: "ES" -- S&P e-mini futures and futures options

Over the next several days we focused on the timefly. Timeflies can be a good way to adjust expirations on an existing position, or as a way of positioning on a calendar for a move that you believe is coming, but not necessarily right around the corner.

VIX traders should give timeflies some consideration, as they can have interesting implications for VIX contango. Think of it as a spread trade vs. another spread trade on VX.

Thesis: Strategy

The market may hang out in this region before moving on to something else. We've determined we want short exposure to ES, but we believe that the market could easily hang out in its current region for a while. We also believe that the S&P is quite overheated, but that it may be due to calm down or pull back. This may enter considerations as we build and modify our timefly.

* Note that our strategy here is fairly simple. A lot of investors or traders put a great amount of thought into their strategy: developing a firm rationale for why they want to invest or trade a certain way. We agree that strategy matters; but tactics and mechanics are often overlooked when determining how to let a strategic directive play out.

Update: ES is up about 35 points from where we initiated our trade on Monday at ES 2322; down 10 points from yesterday.


Last week we determined that timeflies could be an interesting way to take a position given this particular thesis. A visual on the payoff can be seen below. The solid line was P&L movement as of yesterday (the markets were actually closed); the dotted line shows the payoff on the day of expiry on March 3.

Source: Interactive Brokers

The visual demonstrates that our max profit lives at 2280; this is where the Mar3 put expires, and would equate to max profits for the spread. Notice that the spread itself (the solid line) is quite flat for most points on the trade. It is really as we approach the end of the trade (the dotted line) when things get quite interesting.

"So then why close now?"

This is a low-impact trade, and honestly we would not be too inclined to close it in reality; we might trade the mod that we suggested yesterday or just remove some portion of the overall position and let the rest ride out. Still, we began this position last week and committed to close today.

We are approaching the point where theta (time decay) becomes our enemy. The mod that we hesitantly recommended yesterday counteracted this.

Here is yesterday's scenario chart. We'd like to point you out to rows Delta and Theta.

Last Wednesday we discussed the "delta" on this trade. Delta has several different interpretations in options trading, but one of the most important is that delta is the change in the value in an option (or spread's) value if the underlying, in this case ES, moves up by one point.

Delta at 2366 was "0." Moves higher resulted in a low but positive delta (the spread moves higher as the ES moves higher). On the other hand, moves lower on ES correspond to negative delta. In any event, this is good: delta is always moving correctly with the market.

Now how about the bottom row: Theta? For the Feb23 scenario sheet above, observe that theta is nearly always positive. That means that we collect a very modest time premium (due to the ten options we are short having more net theta "signal" than the ten options we are long.)

But today that has already changed:

Mind you, this is for an unaltered trade. This has no modification built in from yesterday. The theta has gotten richer in absolute value: out to $17/day. More problematically, theta is negative.

For further insight on the spread's Greeks, we wrote last Thursday about the spread's gamma; we furthered our analysis on gamma in last Friday's bulletin. Gamma is what is causing the Delta row's values to change. On Wednesday we covered theta.

"How did yesterday's trade mod work out?"

Yesterday we recommended the following:

  • Sell the March 10 2405 call.
  • Buy three of the March 17 2280 put vs. selling three of the March 10 2295 put.

We said: "We'd hold out for a decent buy on this spread, and try and limit into this at around $.60. We'd do it one time vs. our current position."

The trade mod looks as follows:

Now that's a wide bid-ask on today's pricing. In and of itself that suggests that the downside puts are getting "live": Market makers may see these puts as having some vitality to them and want to make a bit more room for themselves.

Why did we suggest this mod yesterday?

Notice that this trade has a positive theta. Recall that we planned on closing out the entire trade (including the mod) today. As such we weren't too nervous about giant moves downward or upward. Because of the 2305 call sale, this mod had a negative exposure to S&P price.

That gives you some color on how we could have modified the position to maintain a positive theta. Obviously this creates its own risks and challenges. Yesterday we put this mod in the "don't bother" category. In retrospect it looks good that we traded it. But we are not big fans at all of overtrading, and with a one-day window to closing, we stick by our guns that we just got lucky on this mod and closing early yesterday (or just hanging on an extra day) made more sense.

Side note: We completely understand the temptation to associate trades that "made money" to be good trades and vice versa. The reality is not so simple. We bring it up now because yesterday's mod looks good in light of today's action. Seriously: big deal!

Mechanics of Closing

Personally, since we had five timeflies and one trade mod that acts like a counterweight, we'd likely close out three of the timeflies first - then close out the mod - and then finish by closing out the last two timeflies. Bear in mind that Interactive Brokers does not have a fixed fee for options trades: all costs are variable costs. Our method may change if we used a broker that charged for instance $10 plus a per contract fee.

These trades are very easy to get done. Given that there is no desperate reason to sell, we'd hold out for a limit and try to get filled near the mid (which should not be difficult to do).

All the options that we are closing are out-of-the-money (OTM). OTM options have better liquidity characteristics. Mechanics are fairly easy to pull off on these kinds of positions. For a closing trade that has more to it, we recommend the mechanics section on our last close.

Closing Thoughts

We'll do a wrap-up on this trade over the weekend to share our thoughts on it. In summary, both the butterflies and the mod each closed profitably. What makes this most interesting of all is that our strategy was not so much correct! We believed last week the market was going to hang out around 2325, and instead we've experienced ten straight moves higher in Dow, with ES trading similarly. Wrong strategy, but the tactics and mechanics actually allowed us to make money over the last couple weeks. Over the weekend, we'll have some things to say about position sizing.

The volatility environment is still quite low, but it doesn't seem to want to throw in the towel quite yet; last Wednesday gave readers every reason to pummel VIX, and it spiked. The VIX has had every reason to get wrecked (nine straight days of all-time highs for the Dow!), but it has not.

Vol is still low, but it feels "tense." Our ES trade was a low-amplitude trade in terms of P&L, which isn't so bad given how screwy the market has been of late.

Have any questions or suggestions? Let us know! Please do ask questions or leave comments. We have gotten some awesome content and questions right from our readers. We really appreciate that.

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Disclaimer: 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 emphasize 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.

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.

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