Mark Sebastian Analysis: VIX and the Markets

Last week I was arguing with my partner Andrew Giovinazzi that volatility was a sale and markets were going to be fine. His response: What else are people going to buy? They can't buy stocks, they can barely buy bonds, and about the only thing that traders and investors can buy is put options and CBOE Volatility Index (VIX) products. That stopped me in my tracks and got me rethinking my trades for the balance of the week. Andrew's, and now my, belief is that the VIX will go up and up and up even as the market sits here no matter how overpriced VIX is. Why? Because there is nothing else to buy.

Recall the last time we had a big debate at the federal level? It was the end of the year in 2012, and the market, much like it is doing now, did absolutely NOTHING for two weeks into the close of business. But, as Dec 31st approached the VIX crept higher and higher and higher, because people were afraid of going 'over the cliff.' The ramifications of going over the cliff, are far less than the ramifications of not raising the debt ceiling. As we head toward October , if we still don't have a deal, I think we could see levels on the VIX not seen since 2011. I am not saying it SHOULD be there, or that it will stay there. In no way do I think we are going to see a 8% drop in the market from here...but that won't stop traders from buying options, because, it's about the only thing they can buy...besides cash.

How does one approach trading vol products and holding stocks and bonds. For starters, I don't think stocks are going to be much rougher than they already are, in my magic crystal ball I see the SPX hitting 1650, maybe 1625 at the lowest, but probably not diving lower wiping out the markets huge gains. Furthermore, when we do recover, look out, we might go right back to all-time highs.

I think the best approach is to trade the wave; buy VIX futures and SPX straddles and ride them for the week. I think they will have a hard time going down, and if one is lucky, they might actually go up. I like VIX call spreads especially because skew is so jacked up right now in VIX. In the SPX, this looks like an excellent week to hold some free gamma in SPX as I do not think we will see lot of decay coming out of the S&P's anytime soon.

For those that are less active, I like the idea of some longer term puts in iPath S&P 500 VIX ST Futures ETN (VXX). A December put in VXX gives the trader a chance to be short a 30-day duration future for the next 90, or so, days. I think that will be an excellent short at these levels. Add in the Sisyphus effect that comes with VXX and I think this one could do well, quickly. I would warn against a large VelocityShares Daily Inverse VIX ST ETN (XIV) position as I have seen that ETN tank on many occasions at a greater rate than VXX rallies. XIV is one that investors can wait to get in on.

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

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