Option Pit Blog
With the German High Court signing off on the ECB bond buying bonanza, the ball is now back in the politicians court. The problem, of course, is that is where the ball has been for 3 years. However, the market looked very favorable at the ruling, which takes a huge chunk of systemic-type risk out of the market for the short term. Or did it? I think there are two parts of the puzzle.
The first has been the very speedy collapse of the term structure in the outer months of the VIX futures. The VXZ measures this by taking a constant duration of the 4-7 month VIX futures contracts. The decline in this product recently has been pretty big. I think the systemic-type risk is being measured here. There looks like a bit more to go on the downside, as the grim future might not be so grim.
Charts by TOS (www.thinkorswim.com)
Second is that the September VIX future closed under the cash VIX. That is called backwardation, and it is a sign of (usually) bad things to come. This is also a very short term phenomena. The bad thing could be the weight the market has packed into the QE3 announcement. Anyone remember the rally when we missed the NFP estimates? The rally thought QE3 would be a lock since employment growth was still sluggish. If Big Ben does not deliver, what holds up equity values in the short term? That could deliver a nasty market shock toward the end of tomorrow. After that, what would keep the volatility up? Any pop in implied volatility will be short lived. If the bad juju specter is lifted from the market, we might just muddle happily along for the rest of the year.
Charts by www.vixcentral.com
The Trade Buy a few ATM call spreads in the Sep VIX options. There should be a good exit at some point during the day. To hedge, buy a couple of VIX put spreads in Oct into any broad market selloff.
Mark Sebastian and Andrew GioVinazzi