Though the equities market has spent the past week digesting its January gains, fear is on the rise underneath the surface.
The normal correlation between stock prices and implied volatility has shifted in recent days, with implied volatility surging in the absence of any major selling.
While the S&P 500 Index (^SPX) is essentially unchanged since Feb. 6, the CBOE Volatility Index (CBOE:VIX) has lifted over 30%. At the same time, the popular VIX futures ETF, the iPath S&P 500 VIX Short Term Futures ETN (NYSE:VXX), is up 18% on higher-than-average volume.
So, what gives? Are savvy traders foreseeing an inevitable correction, or is all this hoopla in the volatility space unwarranted? Unfortunately, only time will tell.
There’s one thing you can bet on, though, is that this current disconnect between realized and implied volatility won’t persist.
With 21-day historical volatility on the S&P 500 hovering at a measly 9% and the VIX north of 21%, something has to give. Either the market is about to become a lot more volatile (read: a sell-off could be in the cards), or the VIX is going to fall from its lofty heights.
And this brings us to two potential trade ideas, depending on which outcome you feel is most likely. If you think market volatility is poised to play catch-up to the VIX by seeing a deeper sell-off in the SPDR S&P 500 (NYSE:SPY), consider selling an out-of-the-money March call spread.
The SPY March 140-145 can be sold for around a 70-cent net credit. (You would sell the $140 call while at the same time buying the $145 to construct this trade.) Think of it as a bet that the SPY fails to rise to $140 by March expiration.
On the other hand, if you think the VIX is unjustifiably high and destined to resume its multi-month downtrend, consider selling an out-of-the-money March call spread on the VXX. The VXX March 33-38 call spread can be sold for around 75 cents (i.e., selling the $33 call and buying the $38 call), and offers a high-probability bet that the current fear surge is unsustainable.
At the time of this writing, Tyler Craig had no positions on any of the names mentioned.