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Watching for Volatility

“There’s nothing wrong here…except that there’s nothing wrong…”

Lt. Col. Hal Moore (We Were Soldiers)

With the VIX closing near 2 year lows at 18 and the S&P 500 sitting at its 18 month high, it might seem that the clouds have parted.  On the contrary, with pressure being put on China to revalue the renmimbi, a Dodd plan with the “most sweeping financial overhaul since the ’30s“, the end of the Fed MBS purchase program looming, and political arguments rising over assistance for Greece it seems to me that now would be a good time to hedge your bets.

The way I am going to make a bet on volatility is to go long the VIX.  If you do not want to dabble in options or futures, VXX as an exchange-traded note is probably your best bet for a quick pickup or a hedge against equity holdings.  If you are more adventuresome, the underlying futures and options provide interesting alternatives.  The first thing to remember is that VIX derivatives trade off of future expectations for the level of the VIX.  What this generally means is that VIX futures trade at levels that are higher than the current VIX with an upward sloping forward curve or in futures lingo, it exhibits contango.

VIX Futures exhibit Contango, i.e. future expirations trade at higher levels

When looking for sharp moves in volatility, shorter term options and futures on the VIX generally perform better as the contracts with more time to expiration are dampened and have a lower beta to current realized/implied volatility.  This leads me to use longer term VIX options for selling (premium generation) while using short term options for hedging or speculative bets.  Currently, April expiration VIX futures are trading at 21.5 versus a spot VIX level of 18.   For a linear exposure, you can either purchase the future contract outright or sell an in-the-money put on the VIX April futures contract.

To leverage your bet for a non-linear option payoff, look at selling ATM (21 puts) on the April VIX contract while purchasing out of the money call options on the April VIX.  You can currently sell 21% April puts for $1.55 and purchase 22.5% calls for $1.6 for a net debit of  a nickel.

April Options: Short 21 put, Long 24 Call pays you over $.25

Posted in Derivatives, Markets, Trading Ideas.

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