Schaeffer's Trading Floor Blog

Is There 'War Premium' in the Volatility Markets?

Inflated volatility, Ukraine, and two global unrest trades

by 3/2/2014 6:55 PM
Stocks quoted in this article:

Same old, same old on Friday. Another day, another failed rally, followed by a failed breakdown, followed by a positive close and new all-time highs. We're above the magical 1,850 level in the S&P 500 Index (SPX), but still not by much.

The CBOE Volatility Index (VIX) ticked lower, as it often does on Fridays. But alas, the iPath S&P 500 VIX Short-Term Futures ETN (VXX), once America's Ugliest ETN, closed up on the day and continued its pattern of general outperformance. We've now gone over five full weeks of trading without a new all-time low. And it's not even particularly close, as we'd need a 10% drop in VXX to get there.

As we noted the other day, VXX is hanging in there thanks now to the consistent premiums in nearer-month VIX futures relative to VIX itself. Or perhaps the buying is starting in VXX itself and spilling over into support for VIX paper. It's a dog-versus-tail debate that really doesn't have any merit. The larger point is that there's elevated demand for near-term volatility paper.

I speculated the other day that it was fear of a move off 1,850 in SPX, but perhaps there's a better explanation. A Twitter friend posited that perhaps there's some war premium in the volatility markets.

It's certainly possible.

If it seems like there's rising unrest in two or three spots around the globe every week, that's because that's probably true. On some level, the market ignores them either right from the get-go or a week into it when it's clear that it isn't leading to anything that's going to wildly shake up U.S. retail spending. But now we have Ukraine and … well, it's certainly possible there's major freak-out potential here. And that gets especially true when you head into a weekend and imaginations run wild that Russian tanks might start rumbling through Kiev by Monday.

Then again, VIX itself did actually decline, so the worries aren't humongous.

I personally wouldn't buy VXX as protection here. Then again, I'd almost never buy VXX, so I'm not a good one to ask. If you are looking for some Global Unrest ideas, Steven Sears has some good ones in Saturday's "Striking Price" column.

Because America is advancing toward energy independence, and the amount of oil produced from our shale fields is expected soon to outstrip that of every OPEC nation save Saudi Arabia, consider selling a put spread on ExxonMobil (ticker: XOM). With the stock around $96, sell the July 92.50 at $2.40 and the July 85 put for 86 cents. This bullish trade, a bet the oil giant will benefit from more U.S. oil, obligates investors to buy the stock below put strike prices.

…The adventurous can consider an iShares MSCI Emerging Markets (EEM) ratio put-spread. This position should prove profitable if investors wake up to some of these overseas problems and sell off even more international stocks. With the fund at about $40, buy the May 37 put at 89 cents and sell two May 32 puts at 18 cents each. The spare short put positions investors to participate in a relief rally once these markets finally have reached bottom.

You always have to be careful on ratio put spreads of course. But odds are it's a low-cost protection purchase with some risk associated with a complete collapse. I'm generally willing to take that sort of risk as you have to consider the timing on a ratio put spread is everything. If EEM goes to the low 30s tomorrow, you're sweating, but if it goes there over time, you actually have a very nice trade on. And I'd suggest low 30s is a long way away and in a product that's probably due for some mean reversion to the upside anyway.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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