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VIX: Where Will It Trade?

This complimentary article from Options Profits was originally published on January 9 at 9:36am EST. Don't risk missing over 40 options trade ideas every week and exclusive commentary from over 10 experts. Click here for more information and a 14-Day Free Trial.

Heading into the second week of January, traders need to prepare themselves for something we haven't seen in some time. The possibility of the CBOE Volatility Index (VIX) falling below 20! I did not think we would get here as quickly as we have, but assuming there is no crazy news overnight, the VIX will be trading around 21.25 on Monday's open with a strong bias to move lower. Lower? One might ask, how could the VIX possibly trade lower, IV is low...isn't it?

Relative to market movement and long-term historical prices the answer is a resounding NO! Let's start with market realized volatility (sometimes called historical volatility). Over the last 10 trading days, the market has moved with a realized close-close volatility of about 12%, looking at ATR (average true range) that number upticks slightly, but not much. Comparing that to a VIX of 20.53, we can see that not only is the VIX not 'low', one could argue that the VIX is astronomically high.

Moving on to the long-term prices, remember the VIX is usually well below 20, with brief periods of extremely elevated volatility. Over the long haul, the mean of the VIX is right around 20%. Thus, even at 20.5, the VIX is slightly above its average price. It is easy to forget where the VIX has been in the long term past when trader's memories are so short. In 2006, I was trading options in an environment where the VIX was below 12 for months at a time and even touched below 10. As early as April VIX was below 15%.

This information can be quite useful to the retail trader who takes the time to learn these products. Next week something has to give one way or the other, either the VIX has to begin to fall below 20%, or realized volatility needs to uptick back over 17% (that would mean the SPX is moving a little more than 1% a day). They could also meet in the middle somewhere. Regardless, I think right now the environment is somewhat ripe for well thought-out short premium or short volatility plays.

I especially like short volatility plays in the vol products because of the current price of the VIX futures. Right now the spread between the VIX cash and the VIX futures is at one of the widest points in the recent past. VIX futures are trading (adjusted for the weekend) at a 2% premium to VIX cash. If there was pressure on SPX volatilities to drop, there will be even more pressure on VIX futures to fall. I really like owning puts on iPath S&P 500 VIX Short-Term Futures ETN (VXX) and puts on VIX. Both have potentially great things working for them.

VXX roll yield and downside pressure in the futures could have VXX trading below 30 by mid week and possible 25 by January expiration (especially with MLK day coming up). With the IV of the options now below 60% I think puts in VXX are a screaming buy. VIX is setting up for some great short plays based on the theta between VIX cash and VIX futures.

For those that think the VIX could pop, I would strongly suggest playing in SPX over VIX options at this point as VIX futures are overpriced even beyond SPX IV. One interesting play that could be traded by our institutional audience would be to hold SPX straddles in January or February, and then either sell VIX futures or VIX calls to flatten the vega of the straddle. This would still leave the trader long gamma and short theta, but could allow the trader to profit even if IV sinks.

The week ahead could be interesting. Earnings gets under way and there are more bond auctions. However, the performance of the US markets even as the euro has tanked points toward a break in USD/Euro correlation. Assuming earnings aren't terrible, I see 1300 in SPX in the near-term and a VIX below 20.

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At the time of publication, Mark Sebastian held positions in VIX.

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