This VIX Trade Suggests Higher Volatility Could Be Just Ahead
This VIX Trade Suggests Higher Volatility Could Be Just Ahead
Trading volatility – or volatility products – has become extremely widespread. It’s true for options traders of course. But, even those traders who never touch options may still trade (or at least follow) volatility levels.
As you know, overall market volatility is most commonly tracked by watching the VIX. The VIX (S&P 500 Volatility Index) is a measure of implied volatility levels on S&P 500 options.
VIX is popular because it measures the volatility of the most widely followed stock benchmark in the world, the S&P 500. Even if you’re not trading large cap stocks, the VIX is still a meaningful gauge of overall market volatility.
For a more detailed description of VIX, check out the CBOE’s main VIX page.
One of the great things about the VIX for options traders is there always seems to be action in the futures and options. Don’t forget, you can’t trade the VIX directly… just its derivatives. There are also multiple volatility related ETFs available, but none track the VIX precisely.
To read more about VIX futures and options, follow the link.
As I’ve said many times in the past, VIX options in particular are always worth keeping an eye on. That’s where the smart money likes to execute important trading strategies and portfolio hedges.
Here’s a potentially meaningful example from this week…
During the week, a trader bought a large amount of May 16 calls, while simultaneously selling the May 21 calls. The bullish call spread cost a total of $0.44. The spread was executed 37,000 times for a total cash outlay of $1.6 million.
The max loss on the trade is $1.6 million, or the premium cost. The max gain on the trade is almost $17 million, and occurs if the VIX closes at 21 or above by May expiration.
Okay, so what’s the deal with this VIX trade?
First off, let’s look at the chart:
As you can see, the price of the VIX has been clearly trending lower as volatility has come out of the market. The price has remained below the 50-day moving average since February despite testing the moving-average resistance line on a few different occasions.
The trader may believe the VIX will spike above the 50-day moving average in the next few weeks. If so, the spread suggests the VIX spike may be capped at around the highs for the year.
So, given the recent history, how likely is a spike in the VIX?
First off, at $0.44 per spread, this trade isn’t unreasonably expensive. As such, it makes a very efficient hedge against a short-term selloff. With the Fed meeting and other (potentially important) news events ahead, a hedge at these levels does make some sense.
It doesn’t seem likely that a trader would bet $1.6 million on a short-term VIX spike in the name of speculation. While the trade is cheap in relative terms, it’s a lot to lose for a straight up bet on an unlikely scenario. That’s why I believe the spread is probably a hedge.
Yours in Profit,
Gordon Lewis
Note: Gordon Lewis has been trading options for more than 15 years and he now writes and edits for Optionstradingresearch.com. You can sign up for the newsletter and get a free research report. We are your go-to source for top notch options trading research.
Category: Options Volatility Watch
