Volatility has left the building … and so too has fear, apparently. Since spiking to 21 on anxiety surrounding the government shutdown in early October the CBOE S&P 500 Volatility Index (VIX) has tumbled back to the lower bounds of its multiyear range. From its recent peak, the popular implied volatility gauge is down 41%.
So why the recent onset of market complacency? Well … would you believe the time of year?
The next six-week stretch includes Thanksgiving and Christmas, which means we have a couple holiday market closures along with two days where market participants head home early (the day after Thanksgiving and Christmas Eve). Tack on another market closure for New Year’s Day, and you start to see why forward-looking volatility measures like the VIX have succumbed to gravity.
Not surprisingly, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) has suffered alongside the recent volatility ebb.
On a side note, the shelf life of VXX was prolonged last week with a 1-for-4 reverse split on Nov. 9. The reverse split was a welcome development as it lifted the beleaguered ETN from a lowly $12 to $48. Along with extending its persistent downward march, the reverse split allows option traders to structure positions much more efficiently.
Consider the problems that arise when attempting to place option trades on stocks approaching the single digits:
- Even with $1-wide strike prices, a move from one strike to the next represents a 10%-plus move. This severely limits the amount of option strikes that have enough premium to be considered “in play,” thereby increasing the difficulty of structuring a position that’s worthwhile.
- Given the cheapness of options on low-priced stocks, traders might be forced to initiate positions with a large amount of contracts which increases commission costs. For example, with VXX at $50, I might be able to initiate one $5 vertical spread for $300. If VXX is at $11, I might have to initiate upwards of five $2 vertical spreads for the same $300. That’s a 10-contract trade versus a two-contract trade. Depending on your broker, that could make a huge difference in transaction costs.
Provided the VIX remains depressed over the coming weeks, VXX should continue to grind lower into year-end.
Those looking to profit might consider buying the VXX Jan 49-44 put spread by purchasing the Jan 49 put and selling the Jan 44 put for a net debit of $2.87. The max risk is limited to $2.87 and will be lost if VXX sits above $49 at expiration. The max reward is limited to $2.13 and will be captured if VXX falls below $44.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.