Traders following US equity markets closely will be well aware that after hitting a speed bump in late summer, stocks have since then rebounded significantly with many indices now threatening to establish fresh 52-week highs.
As equity markets push higher, especially toward 52-week highs, many volatility traders are no doubt licking their lips in anticipation of new trading opportunities. Many of these traders likely think that equity markets may be exposed to another pullback in the near future, and are looking at volatility products like the VIX index and /VX futures.
On a recent episode of Forward Slash on the tastytrade financial network, hosts Tom Sosnoff and Tony Battista discuss their view that /VX (futures) look extremely appealing at the sub-15 level.
The Forward Slash team doesn't seem to be alone on that stance.
Around the same time Tom and Tony started drawing a line in the sand, the website Zero Hedge published a story with the headline, "Volatility Traders Aren't Buying the Rally."
In this post, Zero Hedge notes that the publication Sentiment Trader recently said of the November 4th, 2015 trading day, "This is the fifth time in the past three years that the VIX rose 2% or more on a day the S&P 500 also rose, and short-term volatility expectations were at least 10% below longer-term volatility expectations."
The post went on to say that Sentiment Trader also noted, "Over the next month, the S&P 500 was not able to gain more than +1% at its best point, and suffered a loss averaging -3.2% at its worst point. Quite a negative reward to risk ratio."
The above illustrates that traders are adding to long volatility positions with markets pushing toward highs. However, that certainly doesn't mean any of these traders will be right.
With the strength the market has shown during this incredible bull market, it seems equally plausible that equity markets could grind higher and manifest themselves in the form of a Santa Claus rally through the New Year.
No matter your take of the current situation in the markets, volatility-related trading products may offer you the right solution for expressing your view.
Tom and Tony focus on this very subject in recent episodes of Options Jive and Market Measures that are beneficial to anyone looking to refine their knowledge and awareness of products centered around the volatility trade.
On the aforementioned episode of Options Jive, Tom and Tony break down the definitions of the VIX index versus /VX futures and provide some valuable insights into trading the two.
The VIX index is a cash-settled product that basically acts as a gauge of supply and demand for S&P 500 options. When SPX options get bid up, the VIX index rises, and when SPX options get sold off, the VIX index falls. It's important to note that the VIX index also has associated options, which we'll get to later.
The /VX futures are contracts that indicate the market's expectation for market-wide implied volatility in the future. The /VX future contract price is determined by supply and demand, whereas the VIX index price is determined by a complex mathematical calculation derived from SPX options prices.
So what connects these two products? The VIX index is also referred to as "spot" VIX. A futures contract with no time left is equal to the spot price of the underlying the index is tracking. So on the last day of a /VX contract's life, the following is true: /VX = VIX.
One of the more complex aspects of the /VX and VIX relationship is the VIX options, and we recommend you watch the full episode of Options Jive dedicated to this topic to get the best possible understanding of the connection.
In the meantime, let's take a closer look at an episode of Market Measures focusing on the /VX futures.
On the show, Tom and Tony discuss the view that /VX can be an attractive product for traders looking to initiate positions that benefit from an increase in volatility - especially when the VIX is low (as demonstrated soon).
The chart below illustrates how the VIX has tailed downward as the markets have recovered from late summer through present:
The strategy that Tom and Tony subsequently detail on this episode involves buying the /VX contract alongside selling upside calls in the VIX. It's vital to note that the structure they discuss involves products from the same contract period.
An example of this trade would be as follows:
- Buy one NOV /VX at $16.50
- Sell 10 of the NOV 18 VIX calls for $1.25
Where the episode really lifts off is the point that Tom and Tony start discussing tastytrade research that examines the success rate of such positions in the past.
In this study, the tastytrade research team backtested that same structure in /VX futures and VIX options from 2008 to present. The parameters of the research were set such that on the day of each VIX settlement, the computer bought one /VX future contract and sold 10 of the first out-of-the-money (OTM) VIX calls in the contract with 27-34 days until settlement.
After calculating those results, they re-ran the same study except filtered it for opportunities only when the VIX was below 17.5 and then when it was below 15... yielding two additional categories to compare against the overall results.
The conclusions from this research are fairly hard-hitting.
The first study, without any criteria for the VIX price, showed that on average only 50% of these trades resulted in a profit. However, after implementing the VIX criteria of 17.5 and 15, the results improved dramatically.
Deploying the trade when the VIX was below 17.5 turned the /VX covered call into a winning strategy with 59% of occurrences on average turning a profit.
Filtering for opportunities with the VIX below 15 yielded some even more enticing returns.
Buying the /VX below 15 and then deploying the covered call strategy raised the success rate from 59% to 63%.
The graphic below illustrates the conclusions from this study and highlights the improvement when using a sub-15 /VX futures and covered call strategy:
- Mechanically buying /VX every cycle has not been a historically profitable strategy, even when selling premium against it.
- Being patient and trading covered calls when /VX was below 17.5 and 15 resulted in profits with win rates over 50%.
Given the complexity of the products and topics discussed in this post, we recommend that you watch the full episodes of Options Jive and Market Measures in their entirety to ensure comprehensive exposure to the volatility trades outlined therein.
We also encourage you to send us any questions or comments at firstname.lastname@example.org
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Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.