Market Volatility Bulletin: End Of Q1 In Focus

by: The Balance of Trade


S&P has picked up since market open, after a weak overnight performance.

We highlight a reader comment with an interesting trade idea.

A trade modification on our ES position.

CNBC: 10:15 EST

ES futures (NYSEARCA:SPY) were down small in the overnight session, pointing to a roughly flat open. Following the opening bell, investors will likely have their eyes on Fed members hitting the microphone, as well as the weekly University of Michigan numbers. Overnight lows were put in at 2356.75, with highs at 2365.75.

Just before market open, the VIX was up small, roughly 0.50%.

CNBC: Thursday Close

The Nasdaq (NASDAQ:QQQ) closed at record highs Thursday, as the banking sector led a rising S&P index. Utilities (NYSEARCA:XLU) posted a lagging performance, dropping 0.68% on the day. The energy sector (NYSEARCA:XLE) closed strongly to the upside, as crude oil for May delivery gained 1.70%.

Commenter Shout-Out

Today we'd like to highlight a reader's comment on an interesting observation in current VIX term structure:

Let's look at the current term structure to help visualize the concept.

The strategy suggested here is quite similar to a time-fly, which we've used previously in our Tracking the Trade segment using ES options. Initiating this trade using only futures would be slightly different, as we would likely use two spread positions. In the first, sell a July VX contract against an August. Then, buy another August VX contract, while selling a September contract against it. As Eric Peterson mentions, we can see that the term structure is generally a straight line throughout, with small fluctuations. Currently the August contract is below where that line would connect July and September, so this trade would seek to profit on a move back into alignment by the August contract.

We'll be keeping an eye on these spread positions, as we think there is interesting potential for profit here. As of just after market open today, the July/August spread is trading at a difference of about $0.50, while the August/September spread is just under $0.80. Keep in mind VX futures contract use a multiplier of $1,000.

Thoughts on Volatility

Yesterday's movement in the VIX markets brought us two interesting observations worth mentioning. First, a jump in both the SPX and the spot VIX, which we've written about before as it's happened. Next, a divergence between spot VIX and front-month VX futures, as displayed below.

While this type of price-action does occur on occasion, it is the exception rather than the rule. In the past, we've seen more of this movement as we near expiration of the front-month contract, so seeing it three weeks away from expiry makes it even more noteworthy.

Clockwise starting top left: VXX, XIV, UVXY, TVIX

To quickly recap the products above: the VXX is a non-leveraged, short-term exposed product, the XIV is a short-term focused, non-leveraged product with inverse exposure, the UVXY and the TVIX are both short-term focused as well, though with 2X exposure to the VIX. For a more in depth look at the products above, click on the links below the visual for our articles including specific product overviews. Except for XIV, these products seek a positive directional exposure to the VIX.

Readers will likely notice how much the performance of these products fluctuate when comparing their movement to the spot VIX. On Wednesday, for example, the leveraged products came quite close to replicating movement in the spot VIX. Yesterday though, the closest product only moved about half as much as the spot index.

Organic vol in the at-the-money region for ES futures options is little changed from yesterday's observations. As discussed earlier in the week, one-week volatility was smashed (high print of 15.3 this Monday for a five-day contract, now at 7.9 for a one-week).

For the time being anyway, we seem to have leveled out. The sudden action lower for ES option vols and corresponding move higher in the S&P feels more like muscle memory to us (Buy-the-Dip) than legitimate response to a stream of events. That is not to say that we think that equities should have melted down this week; it just seems odd that they were so resilient given the news flow of the past seven days.

We think one-month vol is a buy below 9: we're essentially there.

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

On Tuesday we began a new trade to track for a predefined time window. We will be working around the following characteristics:

Trade End Date: Apr 7, 2017

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

Trade Strategy: modified call spread sale

As always, we will track this trade daily to examine its characteristics and study any modifications.

Strategy: Thesis (Set out on Mar 28)

The US equity markets have finally taken a tumble. The VIX doesn't seem to want to go back into its ten-handle range from a few weeks ago, but also is quite resistant to a big rise. We think investors will have a strong urge to buy the dip here at 2335 where we initiated, but this attempt could well be thwarted. We therefore believe ourselves to be in a bit of a holding pattern, where temporary moves to the upside are highly likely.

Given this belief, we want to choose a tactic that earns some time value, and with some overall negative delta but with a bit of relief thrown in.

We will trade the near-dated call spread ("CS") with an offsetting put sale in case of a liftoff.

Note: We got our lift-off pretty quick! Within a couple hours of opening this trade, ES was trading around 2360. That was not a positive for this trade, and we discuss this below. As we write this, ES sits at 2361, identical to where it sat yesterday.


The particular legs we will trade are as follows:

Sell the Apr7 2335 2365 CS Sell the Apr21 2250 Put

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 Apr7 expiration.

"Why did you trade that particular spread?"

We wanted to trade a thesis in a reasonable way: failed rally attempt. We wanted to make time our friend on this position, which it is for a good number of ES handles.

Look at the payoff diagram above. Wherever the dotted line is above the solid line, that means that the passage of time is your friend. Vice versa for whenever the dotted line is below the solid.

Another way to see this is to look at the options sensitivities, or Greeks, for the scenario analysis below. This is from right around where we opened (note that the "current" column has ES at 2337).

You can see that for the majority of cases, Theta (Row 6), or option decay, is quite positive. From the current vantage point, even at its worst it is only negative to the tune of $5/day. Also notice the fairly mild negative delta (Row 3)… this is a pretty interesting call spread!

"What does the trade look like now?"

We paid $1.50 yesterday to modify this position yesterday. Namely we closed the Apr21 2250 put and sold the Apr7 2300 put. This removes any exposure for dates other than Apr7, and changes our basis to $16.25.

"What should you do now?"

Look at our Greeks! Ask how this lines up with our overall strategy.

Currently the spread still pays a modest theta, with a bit of negative vega thrown in. Our P&L is quite contained here.

Truly, this is likely close to where we'd do another. We're not big on doubling down on a position unless our original losses were fairly limited and the underlying has moved in a reasonably dramatic fashion. Our losses are indeed quite limited (to the upside anyway), and the market has moved in a relatively sharp way over the past few days.

"Well, should you double down?"

Our theta starts to become something of a problem after Monday. Let's have a look:

Source: Interactive Brokers

This is not a P&L graph similar to what we usually show. Rather, this is an image of what theta is at varying ES prints by end-of-trade on Monday. Theta essentially falls to zero for the current level of trade come Monday.

Tactic: Open a new, similar trade, while partially closing down the old one.

Recall that our original thesis was a pop higher in ES followed by a failure to hold.

We will partially close our old trade, and at the same time open a new one.

We will buy back a portion of the last call spread: Apr7 2340 2350

We will sell another call spread: the 2370 2380

For those with a background in options trading, you may recognize this profile! We'll discuss what this trade is in the Mechanics section below. For now, let's talk about why we're trading it and what it does to our exposure.

We see that this only very modestly reduces our delta (Row 3), but it allows us to earn an extra $21/day in theta. Recall that at this time the time collection on our original trade has significantly diminished: this tamps it back up.

Tactically, we are simultaneously closing and opening risk

We are buying back the cs for the portion of 2340-50. This is "locking in a loser": strange, given that our thesis was that the ES would pop and then fail.

On the other side, we are expanding out our exposure: we have an extra 10 handles of down side to contend with (2370-80), which can really increase our potential net losses. In this sense our tactic looks like doubling down!


Hopefully the visualization on the spread above looks familiar: it's an iron condor!

The reason is simple: buying an in-the-money call spread is the same as selling an out-of-the-money put spread with the same strikes and expiries. Observe:

The payoff profile for the two are completely identical, but generally speaking it is more liquid to trade the PS. If you look at the original intended spread from above, it was $2.50 wide between the bid and the ask. Granted it is pre-market as we write this, and if we actually tried to get a fill this would no doubt come in some. Still.

On the other hand, trading the Apr7 2340 50 70 80 Iron Condor is about $1 wide. Same strikes, same exposures. We'll limit in for a fill at $5.50. We are picking up a net $4.50 of exposure in either direction, but we're giving our theta a boost for this region.

Closing Thoughts

We believe the market dynamic is shifting from being a place where investors will regret raw positive beta (or delta) to the market. That doesn't mean that there couldn't be more room for markets to rally; it does mean that traders should consider alternative approaches to gaining the exposures they seek.

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.

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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.