VXX - Are Low Volatility Markets Returning
A recent large options trade is making a big bet that markets will remain calm, reports Jay Soloff.
Both 2018 and 2019 have been characterized by periods of choppy markets and higher volatility. It’s been quite the change of pace from 2017, where it seemed like we would never experience market volatility ever again.
Of course, nearly everything in the financial markets moves in cycles. Low periods of volatility will inevitably be followed by periods of higher volatility. Calm markets will eventually give way to choppiness. And bull markets, well, let's not get crazy – bull markets apparently go on forever (and I'm only half-joking).
Most recently, we saw a fair share of volatility in August and early October. You can see from the chart below of the Cboe Volatility Index (VIX), the primary measure of equity market volatility is based on S&P 500 options – that the market experienced elevated volatility during those times.
However, you can also see from the chart that we have dropped back down to a much lower VIX level. And unlike previous periods, the VIX isn't showing any signs of moving higher. Do we see a temporary end to the elevated volatility environment?
Well, volatility can come and go on a tweet these days. However, we may be in for a period of calm as we await the next Federal Reserve Open Markets Committee (FOMC) meeting at the end of October. What the central bank says about interest rates (and what it actually does with rates) could either keep the market in a low volatility environment or cause a repeat of August.
Meanwhile, at least one big trader or fund is selling plenty of calls on short-term volatility, suggesting it isn’t going to go much higher over the next month. The trader was selling calls in iPath S&P 500 VIX Short-Term Futures ETN (VXX), which is a popular exchange-traded product used to track short-term volatility.
More than 9,000 Nov. 29 VXX calls were sold at the 28.5 strike with the share price of around $20.65. The calls were sold for 33¢, which means a total of about $300,000 in premiums collected. That’s the max that can be made on this trade. Conversely, if VXX moves above $28.50, the losses can be unlimited.
Granted, there would have to be an extreme volatility event for VXX to jump above $28.50 and stay there for any length of time. This short trade seems safe. Nevertheless, it’s not the sort of trade any non-professional should make. In fact, I don’t even think professionals should make this trade unless they are hedged elsewhere.
It’s certainly possible that whoever made this trade owns VXX shares or is long volatility in some other capacity. If you do want to sell calls in something like VXX, I strongly recommend using a call spread instead, so your risk is limited.
Regardless, selling this many calls at such a far out strike is still a decent indicator that volatility isn’t expected to jump significantly over the next month. We’ll see what happens after the next FOMC meeting, but if it’s a non-event, we could be in for a very quiet rest of 2019 (at least in regard to stocks).
Jay Soloff is the Options Portfolio Manager at Investors Alley. He is the editor for Options Profit Engine, an investment advisory bringing you professional options trading strategies, with all the bells and whistles of Wall Street, but simplified so all you have to do is enter the trades with your broker.