This past week VIX did much like the rollercoaster VIX ads show, it went up and then came right back down. It was a hectic week which is typical of the week when the employment number is released on Friday. After the ride VIX ended the week up only 0.09 and the front month future was lower. Looking a little farther out, the futures all shifted lower, probably reflecting fleeting hope that we do not bump up against another Washington, DC imposed financial deadline.
On Wednesday a trade came into the VIX pit that caught my eye. Someone sold 15,000 VIX Dec 16 Calls and bought 15,000 VIX Dec 30 Calls at the same time for a net credit of 0.54. Excluding commissions this comes to $810,000 (15,000 x 100 x 0.54) of income. The goal, if held to expiration, is for December VIX settlement to be under 16.00 in the middle of December. If the trade is held to expiration and all options expire with no value the result is a profit equal to the income taken in. However, this trader was not done and there was another leg to this trade.
The same trader also bought 7,000 of the VIX Jan 16 Calls and sold 7,000 of the VIX Jan 30 Calls for a net cost of 1.25. The absolute dollar amount for this trade was a cost of $875,000 (7,000 x 100 x 1.25). When combined with the income taken in from the leg of the trade using December options was a cost of $65,000. The goal for the January trade is for VIX to have a spike sometime between now and January expiration, preferably over 30.
There are several moving parts and potential questions here so I’m going to break them down.
First, why did the trader sell the VIX Dec 16 Call and buy the VIX Dec 30 Call? There are two reasons – first the trader has an outlook that involves VIX not moving too much in the next couple of weeks and settling under 16.00 at expiration. The second involves money or reducing the cost of the overall trade. The trader is taking in $810,000 of income that they are going to apply to the leg of this trade using January options.
Second, the January VIX option trade is very bullish on VIX. What is the VIX bullishness based on? When you expect VIX to move higher that means you have a negative outlook for the stock market. Historically there has been an inverse relationship between price changes for the S&P 500 and VIX. VIX also reacts based on the nature of the price drop that may occur in the S&P 500. If a drop is quick and unexpected the reaction for VIX to the upside will be even more dramatic. For this trader some sort of ‘volatility event’ in the stock market would result in a quick profit for this spread trade. Odds if we get a quick spike in VIX the trade would be looking to scale out of or exit the trade very quickly.
Astute traders may notice that this trade is a modified version of a calendar spread. Usually a calendar spread involves selling a nearer dated option (the VIX Dec 16 Call) and buying a longer dated option (the VIX Jan 16 Call). So why did this trader choose to purchase the December 30 call and sell January 30 strike calls? Risk control is definitely one reason. In the case of being short the VIX Dec 16 Call, the long VIX Dec 30 Call position protects the trade against excessive losses if VIX runs up in the next couple of weeks. It has been awhile, but VIX did get into the 80’s in 2008 and another unexpected financial crisis could result in a similar move in VIX. As far as selling VIX Jan 30 Calls, those options brought in some income that offset some of the cost of the purchase of the VIX Jan 16 Call.
Finally, if this trade is based on a bearish outlook for the S&P 500 why is the trader using VIX options? VIX can move very quickly to the upside when there appears to be weakness in the S&P 500. For a the right ‘type’ of market move such as a one day loss of 2% to 3% VIX can easily rise 10% or more. That sort of leverage attracts traders that expect a potential drop in the stock market to purchase VIX call options.
Knowing the exact outcome of this trade is difficult since December and January options may react differently to market moves. However, I can determine the best case scenario which involves two steps. First the December positions are held to expiration and VIX settles under 16.00. Second VIX runs up to 30 or above and the January positions are held to expiration. Since VIX options are cash settled, at any price at or above 30 the trader would receive 14.00 per contract. In real dollar terms that is $9,800,000 (7,000 x 14.00 x 100). Of course the trade cost $65,000 to initiate so the net profit comes to $9,735,000. A lot need to go ‘right’ for this trade to yield that significant of a profit, but that is a pretty nice payout of things turn out as this trader is expecting.