As we discussed in yesterday’s article, there was a major explosion in VIX/Volatility related products that contributed to a negative feedback loop. This caused the VIX to surge and the ultimately the failure of several volatility ETNs were well beyond what should have occurred from a two day 6% decline in S&P 500 Index. For options trading, this was a serious disruption, but it also presents an opportunity.
The market dislocation caused by the ‘death’ spiral of XIV and other products makes it important to establish a bearish position the iPath S&P Volatility (VXX).
- Historically the VIX would increase 5% for every 1% decline in the S&P 500. On Monday it surged over 100% or 3x what it “should” have.
- Historically the VXX moves 2% for every 5% move in the VIX; meaning it “should” have risen approximately 45%. At its peak it was on Tuesday was up a whopping 80%.
While we may indeed be entering a higher volatility options trading regime (I mean, we could stay below 10 forever), I think VXX has overshot. Not only is it likely to revert to the mean, but it will likely also resume the downward trend caused by rolling of cantango futures.
Under a normal term structure, the VXX loses approximately 5% per month due to the rolling of the futures. This is why over time it approaches zero.
The TRADE:
-Buy VXX Feb (2/23) 43 Puts
-Sell VXX Feb (2/23) 39 Puts
For a Net Debit $2.10
Assuming volatility reverts towards its historical average of around 17 and the term structure resumes the natural cantango, VXX shares should drop by about 15% or towards the $37 level.
This would place the spread fully in-the-money, delivering a 90% return over the next two weeks.
