Last week the S&P 500 went on a tear to the upside and VIX lost 12.50%. The curve shifted and went back into contango. Before the S&P 500 started to put up new highs there were a couple of sizable VIX option trades that I found of interest.
Usually leading up to a Fed announcement things are pretty quiet around the CBOE floor. Also, on VIX expiration day (Wednesday was December expiration) the VIX pit is usually not the busiest market around. However, Wednesday morning before the Fed announcement there were a couple pretty interesting VIX option trades the came into the pit. These trades were done in several lots and different prices so the numbers are being rounded to the nearest 0.05. I do this to keep the math fairly simple also the size of the trades is a rough estimate give or take a few hundred contracts. Finally, going through the tape it appears both were executed in the first hour of trading.
At the time of these trades the spot VIX index was around 15.50 and the January VIX futures contract was trading around 15.10. Both trades basically have the same sort of ‘idea’ behind them, but we will look at them one at a time.
Trade 1 –
Sell 27,000 VIX Jan 15 Puts @ 1.20
Sell 27,000 Jan 15 Calls @ 1.30
Buy 27,000 VIX Jan 22 Calls @ 0.40
Net Credit of 2.10
Experienced option traders can see that the VIX Jan 15 Straddle was sold for 2.50 and then part of those proceeds were used to buy the VIX Jan 22 Calls at 0.40. This resulted in a net credit of 2.10. The payoff for this trade (if held to expiration) shows up below.
The best case scenario would be VIX settlement at exactly 15.00 with the result being a profit equal to the 2.10 credit received when putting the trade on. Settlement at exactly 15.00 is highly unlikely, but VIX options are cash settled so if the intent is to hold the trade through expiration then the trader will just have to pay cash based on how far in the money either the 15 put or call are in the money. To the upside there is risk limited based on the long position in the VIX Jan 22 Call.
At any VIX settlement level over 22.00 there will be a maximum loss of 4.90 incurred. Again this is assuming the trade is not exited before expiration. Theoretically there is more risk to the downside, but VIX has maintained a floor over 9 over the last 20 years. Finally, the break-even levels for this trade at expiration are 12.90 and 17.10. At any settlement price between those two levels the result is a profit, but a profit that is less than the 2.10 received when the trade was initiated.
Trade 2 –
Sell 10,000 VIX Jan 16 Calls @ 1.05
Sell 10,000 VIX Jan 16 Puts @ 1.90
Buy 10,000 VIX Jan 19 Calls @ 0.70
Net Credit = 2.25
Again what we have here is selling a straddle and then buying an out of the money call with part of the proceeds. The net result is a credit of 2.25, but with different strike prices than the first trade there are different risk and reward parameters around the trade. Another payoff diagram appears below to show how this trade would work if held to expiration.
This trade works out best if January VIX settlement is right at 16.00. All options would expire with no value and the profit for the trade would be equal to the 2.25 credit taken in when the trade was initiated. The break-even levels are 13.75 to the downside and 18.25 to the upside. VIX settlement between those two price levels will result in a partial profit. Finally, the worst case scenario on the upside involves VIX settlement at or above 19.00, but the maximum loss would be capped at 0.75. There is more downside risk and theoretically if VIX went to 0 the trade would result in a 13.75 loser. The lowest VIX closing price is over 9.00, not saying that VIX cannot go lower than that, but based on VIX history it is very doubtful the trade would lose 13.75.
Both these trades have a fairly neutral outlook for VIX through expiration on January 22nd. VIX has been in the mid-teens for most of 2013 and it appears one trader thinks that will continue at least into January. Any sort of market ‘event’ that quickly pushes the S&P 500 down would probably result in an upside move in VIX. The call purchases combined with both short straddles are in place to protect against just that.