2019 can be roughly divided into two market regimes. There
were periods of high volatility and market choppiness, notably in June, August,
and early October. Then, there were the stretches of low and falling volatility
January through May and mid-October through the end of the year.
It certainly seemed like January of 2020 was setting up to
be a part of the low volatility market regime. After all, there really wasnt
much in the way of bad news on the horizon. Interest rates are set to be
ultra-low for the foreseeable future. Progress was being made in the trade war
with China. And, the U.S. economy was generally looking resilient.
Of course, if the market was easy to predict, there would be
no reason to trade (because every move would be priced into all assets
already). Part of being an effective trader is knowing that anything can happen
at any time. Thats why hedging and risk management occurs.
Sure enough, 2020 has already provided a big surprise with
the U.S. killing a key Iranian official. It looks to be the start of much more
severe tensions in the Middle East. Military conflict of any kind adds
uncertainty to the global financial markets. Its especially true when the
potential war zone is a major producer of the worlds oil supply.
After the Iranian news hit, the price of oil shot up, and
but not as much as you’d think. There’s a lot of investors who are
bullish right now. Apparently, it’s going to take a lot more than the threat of
war with Iran to cause something akin to a correction.
Thats not to say theres nothing to worry about. If the
situation escalates, market participants could change their tunes. There is
definitely risk in the market right now, like always, just not as much as youd
think given the media headlines.
A massive options trade I came across this week basically supports this view. Its bearish on volatility, but only to a certain extent. The trade occurred in iPath S&P 500 VIX Short-Term Futures ETN (VXX). VXX is one of the most popular methods for trading short-term volatility.
A well-capitalized trader put on a trade called a put
frontspread or put ratio spread. This is a put spread where more puts are sold
than purchased. In this case, the trader bought the February 21st 14
puts while selling double the 13 puts in the same expiration (with VXX at
Heres what is interesting
The trade was made for even money. That is, selling twice
the 13 puts canceled out the premium paid for the 14 puts. The trade was
executed 16,200 by 32,400 times, meaning the zeroed-out premium was over $1.4
By paying nothing in premium, the trader doesnt lose any
premium if VXX stays elevated above $14 by February expiration. Anything
between $14 and $13 is profitable, with the max gain at $13 ($1.4 million). The
risk in this trade is if VXX drops below $13. There’s no protection from $13 to
$0 for the position.
I like this trade because it costs nothing, and there’s a
decent gain potential if volatility continues to fall. However, having uncovered
risk below $13 is risky, especially if/when VXX goes through a reverse split. Basically,
this isn’t the sort of trade you want to do at home. (Besides, margin
requirements would be prohibitive for most traders.)
However, just doing a normal put spread (buying 14 puts,
selling 13 puts 1 to 1) for February is a reasonable alternative if you believe
VXX is going lower. It won’t cost all that much, and you can double your money
if volatility fizzles out in the coming weeks.
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