Market Volatility Bulletin: VIX Doesn't Want To Go To Bed!

by: The Balance of Trade


S&P action is relatively mild, but VIX doesn't seem complacent.

An examination for how to play VIX from the short end.

Tracking our ES trade.

CNBC: 8:50 EST

ES futures (NYSEARCA:SPY) are looking range-bound in the overnight session, though with a distinct bear bias after selling off to Monday lows at 2347.50 early in the evening. The highs posted at 2355.75, and remains uncontested at the time of this writing.

The VIX continued higher (up 1.50%) before the opening bell, after posting its highest closing price since December 2.

Source: The Balance of Trade

CNBC: Monday Close

Though equities (NYSEARCA:DIA) closed slightly higher, tensions remain from both geopolitical and market factors. Evidenced by a 9%+ move in VIX, short-term uncertainty remains high as market participants are willing to pay relatively higher prices for ES options.

The S&P had several sectors finish in the green yesterday, led by the energy (NYSEARCA:XLE) and real estate (NYSEARCA:XLRE) sectors. Financials (NYSEARCA:XLF) continue their struggle, down another 0.26% during yesterday's trading session.

Source: The Balance of Trade


Today we highlight the work of Topdown Charts for their Monday piece regarding NYSE Margin Debt. While absolute levels of margin debt have reached a fresh set of all-time highs, the authors argue that the acceleration/deceleration of this debt is much more important. They make the point that two signals can be generated from margin debt, one each for both rapid acceleration, and deceleration.

Topdown Charts note the spikes leading to peaks that took place in both 2000 and 2007, and compared them to margin debt acceleration during the current period. To put it in their words, "A rapid acceleration of margin debt (which reflects euphoria and frantic rush to cash in on market returns)."

According to the authors, the other useful signal from margin debt comes from rapid deceleration, which flashed warning lights (false alarms in these cases) during both post-crisis periods mentioned above.

Though we'd argue against ever being complacent in the markets, Topdown Charts states a reasonable contention against being overly concerned based solely on this often-cited market indicator. We would also suggest a modification to the analysis that stripped out changes in the S&P itself when considering YoY changes to margin debt. Higher levels of S&P in and of themselves invite higher absolute levels in margin debt. Simply looking at the YoY seems like a great start, but some further modification feels appropriate.

That said, we appreciate Topdown for publishing this study.

Thoughts on Volatility

Elevated VIX levels continue to be the theme this week, even as the S&P 500 sits roughly right in the middle of its April trading range. The argument could be made that since the S&P seems incapable of meaningfully falling, adjustments for risk must be made somewhere, and that it is currently showing itself in these VIX levels.

Compared to term structure from Friday, observe the continued rising of front-month futures prices, which currently trade for above both second- and third-month VX. Currently, spot VIX sits at 14.29, quite close to F2 (May) pricing, which is trading at 14.50. F1 (April) has overtaken the 15-handle, now at 15.10, with F3 (JUNE) at 14.95.

For those participants looking for interesting ways into this volatility market, we offer the following for your careful consideration. It is worth noting that while we often talk about specific trade ideas, our intention is never for you to take these trades as we have outlined them. Rather, we only hope to be conversation starters, leading readers to examine their views and challenge themselves.

While we often focus on ways for readers to get long volatility, the market could be showing a potential way into the short side. The chart displayed above shows the F1-F2 VX spread, which has widened considerably over the last week. By yesterday's close, the spread reached as high as $0.75. For those inclined to "sell the spike" in vol, selling the spread (sell April, buy May) here is likely to be a softer way to gain that exposure than simply selling an outright.

As expiration for the April VX contract expires next Wednesday, this trade would have a relatively short lifespan. Currently, this spread trades for about $0.60; this is down some from yesterday, while still offering plenty of room back to a flat futures curve. If VIX continues higher over the next week, we would anticipate this spread widening further, though a drop in VIX is likely to see this spread fall back towards flat.

Organic vol for at-the-money options on the ES pushed higher at the monthly and quarterly expirations, lower at the one-week mark.

Recall that the $19.25 price on the Apr 17 straddle includes a three-day weekend. This may be impacting the reported implied vol in the IB system.

By way of exploration, we look at the implied vols for the 2350 handle at different expiries near the Apr 17. Below are our findings for maturities from tomorrow's close through the Monday after next:

Source: Interactive Brokers

Intuition tells us that the IB system has this wrong: 7.6% is not a credible vol reading for Monday's close. Our best guess is the three-day weekend is throwing their system for a loop.

Maybe this really is the implied vol for Monday at-the-money, but we'd take that info with a grain of salt. Reader input (as always) would be welcomed on this topic.

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

We discussed the wrap-up on our last trade (modified call spread sale - lost $.75 on the spread when all was said and done) over the weekend.

Yesterday we began a new sim trade. Specs are as follows:

  • Trade End Date: Apr 22
  • Trade Instrument: ES (e-mini futures contract on S&P 500)
  • Trade Strategy: muted short call

Strategy: Thesis (Set out on Mar 28 on initiation)

There appears to be resistance at around 2370 on the S&P. If the market is going to melt up, we do not see it doing so soon. Still, strong earnings reports over the next couple weeks could provide the fodder for a rally, even if it does not hold.

Furthermore, the fact that bulls were able to hold on so well last week in the wake of the air strikes on Syria, the write-down to Q1 GDP, and the weak jobs number, tells us that at least here as we initiate, bulls are not ready to throw in the towel quite yet. The visual from last Friday morning's market action demonstrates this reality.

Finally, we want to pick up vol where it's fairly cheap (to the upside) and sell it where it's a bit more expensive (to the downside). This practice is known as selling 'skew'.

With all this being the case, we will sell an in-the-money call, and hedge with an out-of-the-money call diagonal.

As we write this piece, ES sits at 2350, after having tried out a pretty decent range over the past twenty-four hours. All told, S&P is down about 5 handles from where we sold the call yesterday, but implied volatility is definitely higher.


The particular legs we will open with are:

  • Sell the May5 2340 call
  • Buy two of the Apr28 2380 May5 2410 call diagonal

Let's take a look at the payoff diagram:

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 Apr28 expiration when the 2380 calls expire.

We'll discuss the Greeks in greater depth below. But for now, we will point out that this is a pretty ambitious spread to trade. There is no max loss, whereas the max gain is $1098. Furthermore, at 2355 where we initiated this trade, it is not difficult to assert that we are closer to the bottom than the top of the recent trading range.

This spread should give us some interesting points for discussion in the days ahead. For now, we'll simply acknowledge that this is a chunky spread, especially for a baseline sim account with perhaps $50,000 in it.

That's fine. These pieces are educational in nature, and it's not necessarily bad to try out some trades that are a touch on the riskier side, so that you can learn how to deal with them in case you get into trouble. Better to do it early in a sim account!

"What do your options sensitivities ("Greeks") look like?"

This is what our position looked like at initiation. Note that this P&L is quite asymmetric for larger moves, and not in a good way. That comes down to positive vs. negative gamma (ours is negative at this time, and remains so under most scenarios).

Generally the offset to negative gamma is positive theta. And indeed our theta (bottom row) is positive under most market scenarios. Though for the present strike, theta is quite muted.

Another feature of this trade is its negative vega (fifth row), or put differently its inverse relationship to changes in implied volatilities.

Now, one thing that is not understood clearly enough, that when one takes a position in an option or a spread, they are not literally trading VIX, but rather the implied volatility on that (or those) particular option(s).

As can be seen, our vega is negative across the board. Implied vol for most strikes and handles picked up yesterday, and as we'll see in just a moment, this harmed us.

So as of yesterday, the spread we put on had negative exposure to ES, slightly positive exposure to time, and negative exposure to changes in implied volatility. Gamma is neutral here, but becomes negative for large moves up or down.

"Why the negative vega?"

This acts as its own sort of hedge. Recall that this is a negative-delta trade: higher moves in ES hurt this position. Generally, though not for any reason intrinsic to options themselves, if and when ES shoots higher, implied volatilities drop. It is also true that there is a strong relationship between moves lower in S&P and increases in implied volatility.

This spread uses this trade-off as a hedging device. Think about all the times that vol has gotten crushed over the past several months on moves higher in the S&P.

Not that we want ES to move higher! Quite the contrary. Still, if we are going to get short ES, this seems a reasonable way to do so.


Yesterday the bid-ask on this spread as we looked to open was $21.45-$23.70 credit (see left side of payoff visual above). Now bear in mind that for any spread above $5, ES options are tradable in quarters; so $21.45 for the ask is the way that IB displays it, but is not a tradable price.

We limited into this trade yesterday after having held out for a better price; in this particular case we got it. If we had not gotten it, we would have to jettison the trade, or adjust our strikes, or sell for cheaper.

The price we entered at was a $23.50 credit.

"What's she look like now?"

With an hour before the open, and ES at 2350, the spread trades for a mid credit of $22. That's a $1.50 increase from where we limited it.

We suspect that you could day-trade variations of this spread (not the whole spread though - too wide on B/A) throughout the day today pretty easily. That's not what we do here in these Tracking-the-Trade segments. For now we'll just leave this spread alone.

Before we go though, we will point out that with theta marginally positive, where we may (but not necessarily will) get a positive bump from a market just trading in a small range would be more likely to come from toned-down levels of implied volatility. For now though, vol does not appear to want to go back in its cage…

Closing Thoughts

If you've read us before, you know that we believe the winds of change are blowing structurally on past trade homeruns such as buy-the-dip or selling VIX on any short-lived spikes. Regardless of how long it takes for these past winners to unwind, two things are true:

  • It hasn't happened yet. We think many of the causal factors that led to these strategies being such homeruns are diminishing and dare we say even reversing. Regardless, as the past two weeks or so have demonstrated, it is difficult to deny that the old guard still holds the keys. Trading and investing needs to be a combo of looking forward, but also trading the market you have.
  • The economic, monetary, and geopolitical backdrops against which various "big" markets like Treasuries, gold, oil, VIX and S&P trade are pivoting to a world beset by greater uncertainty. We believe the Fed's decision to begin unwinding its balance sheet this year effectively amounts to a "Fed call" - where good economic data simply make the Fed more ambitious in terms of how aggressively it unwinds its $4.5T balance sheet. No major central bank has truly taken out a call on economic activity since at least 2010 in our view (ECB raising rates coming out of the Great Financial Crisis… led to 2011's breakdown). We shall be testing new waters in the months ahead.

Now is a great time to methodically education oneself in preparation for more turbulent times.

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.