With the CBOE measure of market implied volatility (VIX) at all time lows despite so many potential risks (Europe, Presidential Election, QE etc) the “obvious” trade has been long volatility. Unfortunately this has been a losing trade for months as the VIX has gone lower and lower. So why is this? And can we play it differently armed with this knowledge?
Why VIX is low
The VIX is a strange beast. It’s priced as a complex weighted average of volatilities on SPX options with the key determinant being out of the money (OTM) puts.
Usually perceived risk produces increased demand for these OTM SPX puts, to hedge long positions and as a long volatility play, thus increasing their IV and hence the VIX. This is where the concept of the VIX being the ‘fear index’ comes from.
However in recent times, despite the obvious risks at present, this has not happened (see the VIX graph below). Why?
First, there has been a whole lot of money lost in recent times in the game of chicken played between volatility and the market; once bitten, twice shy traders are staying away from these plays.
Second, volume is low due to the summer break and hence there are fewer OTM put purchases happening.
Third, the VIX calculation doesn’t include weekly options (for historical reasons). Hence, many short term volatility plays are excluded.
And finally, and most importantly, realized volatility is low; it has been less than 10 for several weeks now.
Will this change? Most commentators believe so and history backs them on this.
In additional, a potential catalyst occurs this weekend: Ben Bernanke’s speech to the annual Jackson Hole conference. Any deviation from the market’s expectation – him keeping the option of QE open without actually committing to it – will produce volatility.
The question is really about timing. If the speech doesn’t produce IV increases other events (Spain? U.S. debt?) might in the near future. But it will be difficult to time any volatility move.
One of the traditional ways to trade short term volatility is via the short term volatility ETN, the iPATH S&P 500 VIX Short-Term Futures ETN (VXX).
However, if the VIX is strange, then VXX is even stranger. It’s a portfolio of front and second month VIX futures with a weighted average term of one month. Each day front month futures are sold and second month ones purchased to retain this average (plus an interest rate adjustment). This causes the infamous negative roll yield as later VIX futures tend to be higher than earlier dated ones; a phenomenon known as contango. All things being equal the VXX will drift lower; by 8% over the course of the trade below.
However, short term volatility can cause VIX futures to rise, with the short term ones rising more. Hence the VXX would rise sharply due to the higher futures plus the reversal of some or all of the contango.
Therefore we have an instrument that tends to drift lower with the potential for large spikes. In an environment where there are lots of potential causes for one of these events; the Bernanke speech being a good example.
How do we take advantage? A 2:1 call ratio backspread is a good choice. This comprises an ATM call sale combined with twice as many OTM call purchases (usually chosen to make the trade delta neutral initially). Here is then the exact trade with VXX at 11.70:
- Sell 10 Oct12 $12 call
- Buy 20 Oct12 $14 calls
- Credit: $180
- Margin: $2,000
A slow decline produces a 9% return on margin (i.e. the $180 credit is retained). However the real money is made if and when there is a return to volatility; a significant worsening of the Europe situation, for example, could send VXX well over the 15.82 breakeven point.
We are, of course, betting that the VXX will not drift slowly upwards; a belief which is consistent with its recent behavior. Should the VXX, however, move up to 14 we will review and either take off (if we believe no significant event is imminent) or keep on (if we believe we are passing through 14 on the way to a much higher level). The choice will depend on the situation at the time.
We have therefore constructed a trade that earns a small, but decent, return if nothing happens; with the potential for a big pay day if there is a volatility event. Try to put it on before the weekend if you can. There could be a big move after Bernanke’s speech.
Just be careful you understand it if you’re still a beginner. This is a complex three legged derivatives spread on an Exchange Note comprising daily rebalanced futures of a measure of the implied volatility of a set of derivatives on an index of 500 equities. You don’t get much more options hardcore than that.
But if you do put it on you may be rewarded with a big move. Or be paid $180 just for waiting.
(A version of this article appeared on Seeking Alpha)