Market Volatility Bulletin: Happy Quad Witching!

by: The Balance of Trade


VIX futures roll to an April front-month.

Implications of a backwardated VIX market on ETP performance.

We offer a more in-depth response to reader comments.

We continue tracking our ES position.

CNBC: 9:20 EST

US equity futures (NYSEARCA:SPY) traded with a tight range-bound sentiment in the overnight session, as participants eye the start of the G-20 finance meeting, which begins in Germany today. Looking towards today's data flow, the weekly Michigan numbers are set to cross the wires beginning at 10 AM EST, with the Baker Hughes rig count to follow, and CFTC net speculative positions as of Tuesday will be released at 4:30 PM EST to round out the week.

CNBC: Thursday Close

Though once again buying was observed into the day's closing bell, the two most widely followed US equity indexes (NYSEARCA:DIA) finished Thursday's trading session modestly lower. The Nasdaq (NASDAQ:QQQ) and Russell 2000 (NYSEARCA:IWM) indexes were able to finish higher though, with the Nasdaq closing just above the 5,900 level.

Stocks were dragged down by the utilities (NYSEARCA:XLU) and healthcare (NYSEARCA:XLV) sectors yesterday, as they lost 1.10% and 0.97%, respectively. The energy sector (NYSEARCA:XLE) also underperformed even as crude oil futures for April delivery finished the day only slightly lower. As a side note, crude oil futures have rolled over as of early trading Friday morning, as the contract for May delivery is now trading with higher volume. Though it did so quite modestly, the financial sector (NYSEARCA:XLF) was the top-performing S&P sector yesterday, gaining 0.16% during the US session.

VIX is up slightly in overnight markets, but still inside of its 30-cent range from yesterday. As with crude oil, VX futures volume has rolled over to an April front-month. The March contract will continue to trade until next Tuesday.

Article Shout-Out

Today, we feature a brief Daniel Goldman piece for our readers. Published yesterday afternoon on Seeking Alpha, the article is titled "The Yen Vs. The VIX: 2 Aspects Of Attitude Towards Risk". In it, the author discusses the recent range-bound movement of both the USD/JPY currency pair and the CBOE Volatility Index, and what their movement signals for risk sentiment from investors.

Mr. Goldman begins by taking a longer-term look at the two instruments (the chart above is a 20-year time frame), and remarking that while the two clearly do not move together, they measure two very different aspects of risk. From the author:

People do not move to safe haven assets when "stuff" hits the fan. They move to safe haven assets when they do not want to deal with a high degree of risk. That means, even if people do not currently expect risk, if they are unwilling to tolerate risk, then they will still move to safe haven assets. Therefore, the yen is less an indicator of current or expected risk, and more a measure of how much risk people are willing to take on: investor's risk appetite.

The VIX, on the other hand, is a measure of the expected 30 day volatility in the S&P 500. It is a measure of how risky investors expect the market to be, in the near future. So if people are willing to take on a lot of risk, the yen may stay weak, even if the VIX is up, etc.

The author finishes the piece by looking at a more recent time frame of the two instruments (the chart above is on a one-year time frame), noting that the USD/JPY volatility around Wednesday's FOMC statement was likely more due to a weakening of the dollar than a decreased appetite for risk. Mr. Goldman, while acknowledging that one cannot make exact predictions of the future, is looking for an increased chance of an overall market correction if the USD/JPY falls below support at 111.50.

Thoughts on Volatility

Let's start with a quick look at the current VIX futures term structure:

As noted previously, we see the front-month future moving down to meet the spot VIX price; we expect this to continue during trading today, as well as early next week, until the March contract expires on Wednesday. Though the front-end contango is still quite steep at just under 12%, notice that the entire curve has flattened somewhat.

Next, we'd like to highlight a brief discussion which took place in the comment section of yesterday's article between DDIV and lzl1007. The discussion began with lzl1007 opining on whether a leveraged-long VIX ETP such as TVIX would make a good short candidate, considering how it acts during times where contango is present in the volatility market (which is almost always).

The conversation then moved to what types of market-moving events would cause the VIX market to move into backwardation, and what to expect from the VIX ETPs if this were to occur. For an explanation of a VIX market in backwardation, let's look to one of DDIV's comments, where we feel as though it was explained quite well:

Other than a small spelling mishap, this is the essence of a backwardated VIX market. Here's a visual look at a VIX market in backwardation. We'll use DDIV's example of during Brexit news last summer.

Though not perfect (the markets rarely ever are), this is what a backwardated VIX market looks like. Higher prices up front, with lower prices on contracts expiring farther out into the future.

As for how some VIX ETPs respond to these situations, let's recall our discussion of UVXY. Though not exactly the same as TVIX, it is similar enough that the following holds true for it as well.

Similar to the VXX, and due to the contango present in the VIX futures curve, UVXY administrators are in an almost constant state of selling cheaper, first-month futures contracts, and buying more expensive, second-month futures contracts. But now rather than enacting this process on a one-for-one basis, now it is on a two-for-one basis. The contango can be crushing, as can the rebalancing on 2:1 daily trade exposure.

The continual exposure to the VIX contango is part of the reason that the UVXY is generally not suitable as a buy-and-hold position for most investors. What the UVXY does provide though, is a 2x-leveraged means to express a conviction that a large move is coming in the very near-term.

Now, what does this mean for someone looking to short a long-VIX ETP in a backwardated market?

It means that the inverse of the situation described above will hold true, and will continue to work against your position. In that instance, fund administrators would be in a constant state of selling more expensive front-month contracts, and buying the cheaper back-month contracts, causing the ETP to rise in value.

Thanks to both lzl1007 and DDIV for reading and commenting! Look for an expanded discussion of TVIX next week, as we look to continue our Product Highlight series.

Organic Vol is down meaningfully over the last couple days since the Fed meeting. As is to be expected, front-end suffered most. Even the one-quarter expiry is down about a vol point for ATM. Observe the "VIX contango" as you move down the second column! This isn't literally VIX contango, but it's not far!

At these low vol levels, short positions in ETPs such as XIV are highly reliant on continued complacency in the market. If you are short vol - good on you (yet again!). We'd say slowly and gently scaling out and bracing for better future entries makes some sense.

Tracking the Trade* (please read disclosures) - Trade Initiation:

In Tuesday's bulletin, we began a new trade to follow over the next two weeks. We will take the perspective of someone who has about $50,000 in cash in a trading account, with no current positions, who wishes to speculate on a market sell-off.

Trade End Date: Mar. 24, 2017

Trade Instrument: ES (e-mini futures contract on S&P 500)

Trade Strategy: Modified Risk reversal

Strategy: Thesis (Set Out On Mar. 14)

We are of a mind that the S&P 500 is an over-believed market. Market internals appear to be getting sloppy. The aftermath of the Fed meetings could provide opportunities for some of the S&P to trade over a broader range of values, with movement favoring the downside. As of this morning, the market exhibited low price movement but did rally into the close yesterday.

We also believe that the market is presently range-bound, and that a meaningful narrative shift may need to occur in order to make the S&P sustainably shift into a different range (either up or down). So far we are still within the range of where we've been for the last couple weeks, but we're near the top end, and it is possible that with the Fed out of the way, we could get our new range.

To implement this strategy, we will work with a spread known as a "risk reversal". We'll refer to the spread as a "RR". In the Chicago trading pits, these are short-handed to being called "a risk".

For a pure RR, the strategy is as follows:

For a particular expiry, buy an out-of-the-money ("OTM") put. For the same expiry, sell an OTM call.

Buy an OTM put, sell an OTM call. That's the essence of the spread. In retail these are frequently called "collars", but we here are using the terminology that is used in the trading pits: "RR". In fact, in Chicago terminology, a collar is long a put spread, short a call; similar, but not quite the same.


The specific RR we implemented was:

Buy the May 31 2,250 put; Sell the Apr. 28 2,410 call.

These two options have different strikes, and as such, this might be considered a modified RR.

Source: Interactive Brokers

The solid line shows P&L for varying levels of this trade as of the day of initiation, whereas the dotted line shows the "final" P&L as of the Apr. 28 expiration.

It is clear that this trade is not very different from "going short" the S&P 500. It has "unlimited downside", and it has more or less unlimited upside. From a practical standpoint, the risks are fairly balanced, especially if monitored and adjusted properly.

"Where does the trade stand now?"

With the ES at 2,378, there is a 299 x 252 market priced with a $1.00 midpoint debit. That means our position is up $2.50 from yesterday, but still down $6.75 from where we initiated. With a 50x multiplier, that is $340 after commissions, 0.68% of our theoretical $50,000 sim account.

As we wrote yesterday before the move higher:

This is a pretty chunky trade for a $50,000 trading account. Losses need to be considered relative to what the needs of the owner are and what other assets this particular individual has.

For instance, say this individual has a portfolio with $1,000,000 and it is long stocks and bonds. This account is more of a way to learn trading and hedge losses. Well, if that is the case, then perhaps meaningful losses in the trade account are relatively acceptable. If, on the other hand, this is the one and only account that the trader has and they cannot afford to lose much, then this is really not the best way to trade their thesis: too much risk.

"Why'd you use these expirations?"

Yesterday we received a question from MorgC:

Why purposely generate a mismatch between our trade horizon and the option expiry?

This is a $50,000 account with a short position that can move quite a bit; we initiated the day the Fed met.

Here are our current Greeks, three days later and having had the trade moved against us:

In general, short-dated options are more rigid than long-dated options. That is to say that short-dated options have more gamma, at least for local ranges. This translates to the fact that we were able to get our exposures while keeping our strikes more distant; if we had wanted to pay a similar debit, and we wanted similar exposures using Mar. 24 dates, then we would have needed to set the strikes much closer to the then-current level of 2,360, where we initiated. This current move higher did hurt us, but it would have hurt us more had we used next week's expiry.

Thanks for the question MorgC - hope this helps!

"Why did you use different strikes?"

We wanted something with a chunkier and perhaps more resilient exposure to implied volatility should the ES fall (positive net vega) while having a chance to collect modest theta should it rise (positive net theta). We wanted to give ourselves some room and not run into tons of trouble on gamma. This is why we chose end of April for the call, and end of May for the put that we purchased.

Naturally, this trade could have gone either way: it still might! Our general finding is that we are still near the top of a range, and the Apr. 28 call is just a bit outside that range. Those calls frequently get pounded if the market calms down, as vol skew sets in.

This RR spread presumes an investor who was considering a raw short ES futures position, but wanted something with a bit more give to it; a spread that mostly acts like a futures, but with modest positive exposure to implied volatility, and some attractive gamma should the trade actually go right.

Mechanics (no changes from yesterday)

We are tempted to make some kind of move here, and if ES moves toward 2,400, we will. Again, for someone with a $50,000 account, this is a pretty chunky play to just own and sit on. Good on them if the market tanks, but how wrong you're willing to be in the meantime comes down to one's personal circumstances, risk aversion, and so on.

For now, we'll just say that the RR was bound to be less wrong that a short futures position if ES rose (which it did), and also less right than a short futures position if ES fell.

Because we track a trade for a couple weeks for educational purposes, we tend to stick to the same overall spread. In reality, this may be quite a good time to consider moving to something else.

We will say that with the modest positive theta and negative vega, the market pays us (though likely not much) if ES just languishes here.

"If you had to hedge this out?"

Tons of ways to do it. But what we'd likely use is another RR that was long a deeper OTM call, short a deeper OTM put. For instance, the May 5 2,200 2,450 RR (sell the 2,200 put, buy the 2,450 call). That could be an effective tool if the trade had you nervous.

Closing Thoughts

A lot of ink is being spilled on whether the various markets "got the Fed correct". What if the Fed meeting was more like a "whisper number", that the Fed missed? If so, then perhaps the movements in the dollar (lower), oil (higher), VIX (lower), S&P (higher), 10-yr yields (lower) actually make some sense. Markets were looking for more.

Our ES trade is down, and we are near the mark where we should think hard about modifying the trade, but we'll say we're not quite there yet.

Regardless of whether you are a "trader" or an "investor" (whatever those words mean!), consider how breaking your ideas down into strategy, tactics, and mechanics could help you incrementally improve in whatever it is you do (or don't do) in the markets.

Have any questions or suggestions? Let us know! We really enjoy reader comments, and post strong comments from our readers with regularity. We appreciate that.

Please consider following us. And check out our commentary on Wednesday's Fed decision!

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 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.