This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Profiting From Cyprus Volatility

TheStreet Premium Services

A complimentary preview
of Options-Profits Previews

Stocks in this article: VIXVXXSPY

Over the weekend, the government of Cyprus announced terms for a bailout that included haircuts for bank depositors. There had been some discussion about a bail-in of uninsured depositors and those with large accounts in the press, but this deal included depositors with accounts with less than EUR 100k, a group more likely to include ordinary Cypriots than Russian oligarchs and foreign tax-dodgers. To avoid a bank run ahead of the announcement, the bailout was planned in secret, and the surprise levy on depositors has already sparked a lot of angst among investors and commentators. A parliamentary vote was delayed until Tuesday, and at pixel time it is still unclear whether the government in Cyprus will end up making the tax scheme more progressive or even eliminate the levy on accounts with less than EUR 100k.

My concern here is with sentiment and market overreaction, so let's begin with some of the more breathless headlines you could have read on the sites of major financial and news organizations over the weekend:

Fig. 1. Hyperbole
Source: Forbes and The Washington Post

 

Markets also responded on Sunday night: U.S. equity index futures were down more than 1%, and the euro fell to its lowest level against the dollar since mid-December. Since the GDP of Cyprus is roughly that of a medium-sized American city, the bailout does not obviously warrant a market selloff on its own. The reason for reduced risk appetites is, presumably, the fear that depositors in other peripheral European countries might become nervous about their own cash and start bank runs.

There is no plausible scenario for any contagion risk from Cyprus to the rest of Europe. The ECB stands ready to backstop accounts in need of liquidity. There is no risk to other European banks or to foreign holders of Cyprus debt anyway, since the debt is not being renegotiated and other banks are not exposed. (They also are still flush with funds from the ECB's operations over the last year). The risk for depositors in other peripheral countries is also nonexistent, as Spain, Italy, etc. have precisely the financial buffers that Cyprus lacks, namely debt that could be bailed-in. The 10%-ish tax on large accounts is effectively a levy on money launderers and oil barons; the rest of peripheral Europe has not styled itself as a pirate's cove. We would be interested to watch the long lines at bank machines in Madrid, Athens, and Rome, if only we could find evidence of any.

This is not to deny the medium-term risks that remain. The inclusion of depositors will raise more questions in other euro-zone countries about the health of smaller banks, as Goldman (GS) explained in a note over the weekend. The deposit tax raises some legal issues and many questions about the arbitrariness of the arrangement.

With markets down sharply versus the Friday close, this looks, however, like a perfect opportunity for all of the would-be dip-buyers who have been waiting for a market entry. An overreaction in U.S. equities will push short term implied volatility higher than it should be, and investors can take advantage of the selloff by buying puts on VIX Short Term Futures (VXX). Once cooler heads prevail, these puts will profit in two ways: first, from an overall decline in the level of the two front-most Volatility Index (VIX) futures contracts, and additionally from a steepening in the futures term structure.

Trade: Buy to open the VXX April 20 puts for $0.92.

The principal risk in a trade like this is that we might be a few days early, but the capital at risk is limited to the premium paid for the puts. If we see more selling in stocks in the first part of the week, we may add a second round later on.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.

Jared can be followed on Twitter at twitter.com/CondorOptions.



Brokerage Partners

Top Rated Stocks Top Rated Funds Top Rated ETFs