Declining volatility usually allows traders to sleep better. However, after last fall’s spike in volatility to its highest level since the Chicago Board Options Exchange created the volatility index (VIX), many traders are skeptical of the recent decline. Volatility as measured by the CBOE’s VIX has declined dramatically — from the upper 80s to the mid 20’s — since last fall’s market debacle.
Are we returning to the lower and more stable days of 2004-2007, where VIX traded mostly in the mid teens, or are we in for another round of volatility just as complacency sets in? Should we expect volatility to continue its recent decline or is this the calm before the storm? In order to trade successfully, these are the types of questions we have to ask ourselves in the current market climate. Although we don’t believe equity prices are enticing at these levels, the recent rally in equity markets is setting up interesting opportunities in the related VIX options.
For those of you not familiar with the VIX, the CBOE introduced VIX in 1993 and it has been the premier barometer in measuring investor sentiment and market volatility. It typically moves inversely to the S&P 500 index. For example, if the S&P 500 declines 2%, the VIX may jump 5% and if the S&P 500 shoots 2% higher, the VIX may decline by 5%. As recently as August 2008, VIX was trading at 18, and as soon as fear spread into equity markets, the S&P began to fall precipitously and VIX began increasing even more dramatically. VIX nearly quintupled (from under 20 to an intraday high of 96) from mid-July to mid-October, while the S&P fell from 1300 to 750 (a decline of approximately 40%). The increase in VIX showed us that market participants had plenty of fear and uncertainty about the future, but the seasonal pattern tracked the historical norm.
McMillan Analysis Corporation
Since that time, markets have stabilized, fear has subsided and VIX has declined below 30 for the first time since September 2008. The VIX drop can be attributed to the S&P 500 climbing nearly 40% off the March lows. Another factor could be seasonality of the VIX itself. Confirming the seasonality influence, Larry McMillan of the Options Strategist provided the above chart. As most traders know, the summer months typically, but not always, have lower volume and reduced volatility. The chart shows that the lowest average reading of VIX comes near the end of June and beginning of July. You may hear pundits talk about how slow the summer months can be in terms of volume and volatility, but McMillan’s analysis of VIX shows a slightly different story. Volatility tends to decrease substantially from mid-spring to early summer. It then begins to increase significantly from the early summer period until mid-fall before abating again into the holiday trading season.
We have put together a trade to take advantage of this seasonality by utilizing a bull call spread on VIX. VIX options are relatively new to the options trading stage, and have proven to be a great tool to trade as a product in itself or as a hedge against long S&P positions. We analyzed the most likely scenarios and we believe the lower end of the VIX trading range will be in the mid-20s over the next few weeks before making a turn higher into the fall. We like going long the October VIX 30 call and short the October VIX 35 call.
The spread recently traded at $1.50 which limits the trade’s risk to $1.50 if VIX remains below 30 at expiration (this spread has been in a range of $1.35 to 1.85 for the last few weeks). A max profit of $5.00 can be realized if VIX finishes above 35 at October expiration. This trade has a potential profit to loss ratio of 3.3:1 and a probability of slightly less than 30% for VIX to finish at breakeven of 31.50 or better. If you take a moment to appreciate and understand the seasonal influences of volatility, the risk/reward of this trade would seem to be on our side.