Record Bet: Trader Sells $18 Million in VIX Calls

Trading is tough business, but trading the VIX is even tougher, because you are betting ‘against the house’ many times. Here’s how to avoid the force that eats into your profits and make it work for you.

Based on Bloomberg data, an unknown trader sold about $18 million in VIX (Chicago Options: ^VIX) calls on Monday.

At the time of the trade execution the VIX was trading near 19. Many of the sold calls had a strike price of 22 with February expiration.

This is a gutsy trade, but is it gutsy smart or gutsy stupid?

The seller of a February 22 VIX call commits to selling the VIX at 22 on or before the third Friday of February. Obviously,  no one wants to buy the VIX at 22 as long as it trades below 22.

Therefore, the above trade will be profitable (seller gets to keep the premium) if the VIX remains below 22.

Based on the weight of evidence, this is a smart trade for the following reasons:

1. The VIX chart below (published in Sunday’s Profit Radar Report) shows overhead resistance at 18.60 and 20.30.

Sunday’s Profit Radar Report proposed that: “Resistance at 18.60 – 20.20 should cap the immediate VIX up side.”

2. The VIX often peaks before the S&P 500 bottoms, creating a positive divergence. This means that even another minor S&P 500 (NYSEArca: SPY) low may not translate into a higher VIX high.

3. Bearish VIX strategies benefit from contango.

Contango is a condition where the VIX futures (price of VIX in the future) trade at a higher price than the VIX spot price (current price). Contango is in essence a premium. The further away the expiration of the futures, the higher the premium.

Some research on the iPath S&P 500 VIX Short-term Futures ETN (NYSEArca: VXX) suggests that the cost of contango is about 0.25% – 0.45% per day. Contango usually occurs when the VIX trades below 25.

The opposite is true as well. Contango erodes gains of bullish VIX strategies.

To illustrate: For my personal account (more or less as an experiment) I bought a March 12 VIX call, which gave me the right to buy the VIX at 12. I bought the call on January 13 for $3.20 when the VIX traded at 11.84, and sold it on January 27 when the VIX traded at 18.40.

The VIX surged 55%, but my VIX call, a highly leveraged vehicle, gained ‘only’ 40%.

The iPath S&P 500 VIX ETN (NYSEArca: VXX) gained a maximum of 20% over the same period of time, and the 2x leveraged VelocityShares Daily 2x VIX ETN (NYSEArca: TVIX) returned no more than 37%.

Keep in mind that this was an extremely well timed VIX trade. If you get the timing wrong, contango will eat into profits and emphasize losses.

The VelocityShares Daily Inverse VIX ETN (NYSEArca: XIV), an inverse VIX ETN, tends to benefit from contango when the VIX is trending lower. XIV somewhat mirrors the call selling strategy explained above.

Based on S&P 500 analysis, the VIX is in for a rocky ride … and many profit opportunities. Here are three reasons why:

Watch for Bounce! But 3 Reasons Why a Longer Correction is Likely

Simon Maierhofer is the publisher of the Profit Radar ReportThe Profit Radar Report presents complex market analysis (stocks, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

The Best Season For a VIX Trade

Forget “sell in May and go away,” the Thanksgiving VIX trade is statistically one of the biggest, if not the biggest, seasonal moves of the year. However, the year 2012 features one rarely seen caveat to VIX seasonality.

November/December is statistically the season for the best VIX trade of the year. On average, since 1990, the VIX drops 35% from Thanksgiving to Christmas.

The chart below illustrates the sharp VIX (Volatility Index) move from the November high to the December low. This year however, investors have to deal with a caveat.

No Slam Dunk – The VIX is in a Funk

The VIX is in a funk. How so? The VIX resisted the usual tendency to rise into Thanksgiving and is currently trading near its low for the year.

This is even more of a head scratcher considering that the S&P 500 (SPY) just dropped as much as 9.5%. Due to the inverse correlation between VIX and S&P, the VIX should have soared for much of November.

Quite to the contrary, the VIX actually dropped during the time the S&P fell hardest (November 7 – 16).

The table below shows the VIX closing price of the day before Thanksgiving and the pre-Christmas low (which has occurred between December 21 and 23 the past five years).

A measured 35% drop from this year’s pre-Thanksgiving close would draw the popular volatility measure below 10, a level last seen in February 2007. This isn’t impossible, but it’s improbable.

In short, the VIX trade doesn’t look like a high probability trade this season. Even at the best of times, it’s difficult to monetize moves of the fear index.

Tough to Profit from the VIX

That’s because the VIX itself can’t be traded. There are tradable vehicles that have been created, but they all have complex idiosyncrasies. Trading the VIX is almost like catching the wind. Many of those unseen idiosyncrasies cause price deterioration and make it difficult to capture profit.

The three vehicles that make trading the VIX possible are:

1) Options 2) Futures 3) ETFs/ETNs.

VIX options are subject to price decay. VIX futures usually find themselves in a state of contango or backwardation. VIX ETFs or ETNs are based on either VIX options or futures (futures are more commonly used).

Contango is a condition where the VIX futures (price of VIX in the future) trade at a higher price than the VIX spot price (current price). Contango is in essence a premium. The further away the expiration of the futures, the higher the premium.

Imagine buying a car and trying to sell it for a profit. As a private party you have to pay sales tax (7.25% in CA). If you buy a car for $10,000, you have to sell it for more than $10,725 (purchase price plus tax) to make a profit. Contango is like the sales tax.

Some research on the iPath S&P 500 VIX Short-term Futures ETN (VXX – the most heavily traded VIX ETN/ETF) suggests that the cost of contango is about 0.25% – 0.45% per day. Contango usually occurs when the VIX trades below 25.

When the VIX rises above 25 it usually suffers from backwardation. Backwardation is the opposite of contango, and happens when the spot price is higher than the front month futures. While contango eats into returns, backwardation can enhance the return of VXX.

VIX Lessons

While we likely won’t trade the VIX this year, the VIX research isn’t totally wasted.

The VIX suggests rising prices and some sort of a year-end rally.

This may provide trading opportunities for the S&P 500 and other equity indexes.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.