A 2-Step Script for Trading Volatility

Last week's VIX spike occurred right after August-dated options on the fear index expired

Senior Vice President of Research
Aug 26, 2019 at 8:58 AM
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"Trade headlines continue to captivate market participants, with the market reacting to the various punches and counter-punches between President Donald Trump and China...

"At last Monday's close, the VIX was at 24.59, or roughly double its 2019 closing low, and, in fact, doubling from the July 26 close of 12.16. I stated on Twitter, there's a possibility of that close being a key peak, due to the VIX's tendency to peak or trough at round-number percentages above or below a key low...

"...historically, roughly 80-90% of VIX call open interest expires worthless, as many calls that are bought are far out of the money... Despite August VIX futures moving as high as 24.81 last week, the contract closed at 18.68 on Friday. This means many of the August 21-expiration calls are in a position to expire worthless."

-- Monday Morning Outlook, August 12, 2019

To say that President Donald Trump lost it Friday morning is an understatement, as he reacted to: 1) Fed Chair Jay Powell's comments -- inferring the president wants more rate cuts now -- after the Federal Open Market Committee (FOMC) head addressed central bankers from around the world in Jackson Hole, Wyoming; and 2) China announcing tariffs of 5-10% on $75 billion in U.S. goods, at which point the president promised a response.

As such, not a lot has changed with regard to my comments from two weeks ago, when I said that market participants have been captivated by trade headlines. On Friday, equity futures plunged pre-market on the China announcement, but stocks managed to get back into the green shortly after the official market open, as some type of countermeasure by China was likely baked in. But a barrage of Trump tweets sent stocks south quickly, as volatility -- measured by the Cboe Volatility Index (VIX - 19.87) -- spiked again. The VIX had pulled back to its 80-day moving average prior to Friday's pop, a trendline that marked resistance in January and a mid-May low.

The two closes below the 200-day moving average prior to the Friday pop proved to be nothing but a head fake as to where volatility was headed and, as such, I am now focusing on a VIX move below both the 18 level and its 80-day moving average before suggesting a potential "all clear" for a rally that has legs.

The way it is now, in order to best time short-term volatility, the script is as follows:

  1. Sell volatility and/or buy stocks when the VIX approaches the 24-25 area, which represents 2018's close and double the 2019 closing low; and
  2. Buy volatility and/or sell stocks when the VIX trades in the 12 area, which is one-half the 2018 close and roughly one-half this year's VIX closing high.

This script is obvious on a chart, but the reasoning behind why these price points are important hammers home the importance of being aware of these levels, both now and in the future when anchoring to calendar-year closes or major highs and lows.

vix ytd chart 0826

The volatility spike pushed the spot VIX above the September VIX futures contract -- a rare condition known as backwardation, and a sign of fear entering the market that typically lasts anywhere from a few days to a few weeks.

After President Trump suggested at the weekend G-7 meeting that he should have raised tariffs more, futures were continuing lower Sunday evening, but reversed after the president announced that Chinese officials called and suggested restarting trade talks.

As I noted on Twitter, the Friday volatility spike occurred just two days after August VIX options expiration, in which a plethora of August calls situated at the 21 strike and higher expired worthless, as the August VIX settlement (VRO) occurred at 15.63. In other words, as is typical, a huge majority of VIX calls again expired worthless -- a reason that I offered two weeks ago in favor of a VIX peak likely being in place for the time being. And wouldn't you know, VIX and VIX futures staged another run into the 20 area just two days after total VIX call open interest dropped by 2.5 million contracts, or 31%, as a result of August VIX expiration.

The quick post-expiration volatility spike caught many investors flat-footed who typically use VIX calls as equity portfolio insurance or to hedge a short VIX futures position. If traders or investors are unhedged, panic can set in quickly -- leaving stocks vulnerable, as we saw on Friday. And this is where we are heading into this week's trading, which means a retest of the recent S&P 500 Index (SPX - 2,847.11) lows and VIX highs would not be surprising.

To the extent that some of the call open interest on VIX futures is related to the hedging of VIX short positions, one would expect that there will not be a huge build-up of calls following last week's expiration of August VIX futures and options. This is because there has been substantial short-covering by large speculators on VIX futures, per the latest Commitments of Traders (CoT) report. Large speculators were once again dead wrong ahead of this latest pop in volatility. This group remains net short, albeit not at the alarming extreme that we saw entering the month of August.

cot lg spec vix futures 0826

In August, amid the drama related to U.S.-China trade talks and Fed headlines, the SPX has mostly been trading in a volatile range between 2,825 and 2,945. Therefore, market participants will likely be focusing on the bottom of this range holding if stocks cannot find footing on the heels of Friday's selloff. As of this morning's pre-market trading, futures are higher, implying the bottom of this range is safe, at least for now.

But another question mark is whether the SPX can continue a pattern of holding its year-over-year (YoY) breakeven level. Coming into this morning's trading, the YoY breakeven is in the vicinity of the SPX's 160-day moving average, a trendline that I have referenced on Twitter and in this report as being significant recently.

Per the top pane in the chart below, the rolling YoY breakeven has been supportive throughout 2019. If the SPX continues to maintain this pattern, it will have to close this month at the round 2,900 level or above. That said, if selling continues this week, an area of potential support lies just beneath this month's lows, with the 320-day moving average sitting just above the 2,800 century mark.

spx daily yoy return 0826

Price action in the equity market has been sloppy, to say the least, as it has been a volatile range. If you are an options trader and think the range will continue, consider premium-selling strategies to take advantage of the recent volatility spike. If you are buying options, ensure that implied volatility (IV) is reasonable relative to the underlying's historical volatility or its 52-week IV range, as some equity options are expensive, despite the fact that we have moved through most of earnings season.

Todd Salamone is Schaeffer's Senior V.P. of Research.

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