Navigating The Illusion of Safety
False security is dangerous. Wall Street's fear gauge is muted. Is the VIX cruising for a bruising?
As mentioned in our previous papers, current times are unprecedented, from geo-politics tensions, restrictive monetary policies, fractured corporate earnings, to sticky inflation. the VIX should be anything but sanguine. Any mild escalation could send equities tanking or soaring at the sight of relief.
When the road ahead is that uncertain, straddle saves the day. This case study argues for a long straddle in CME’s Micro E-Mini S&P 500 Options to gain from price action and from rising volatility.
Low VIX plus narrow spread between VIX & realised volatility reduces straddle cost. Large price action plus volatility expansion will deliver a compelling 1.25x reward to risk ratio.
DEMYSTIFYING VIX
Volatility Index ("VIX") is also known as the Fear Index. Higher the fear, greater the VIX. Typically, VIX above 30 points to elevated uncertainty. VIX below 20 describes stable markets.
VIX is market’s expectations of S&P 500 Index (SPX) volatility over the next 30 days. It is computed by using the weighted prices of SPX options across a range of strikes expiring within the next 23 to 37 days. It is an annualised quantifiable measure of market uncertainty.
Volatility is inversely proportional to the square root of time. A year comprises of 252 trading days. Dividing VIX by the square root of 252 (~16) provides daily expected moves. Current VIX at 20.7% implies ~1.3% daily move.
IS THE VIX BROKEN?
Several threats loom yet VIX remains subdued. Is it broken?
In a recent FT Alpha Ville column, journalist Robin Wigglesworth postulated that the VIX may not be broken. Instead, it has been diluted by product innovation resulting in risk pricing windows shifting away from VIX’s target expiry range.
Growth in short-dated options (including zero days-to-expiry or 0DTE options) has shrunk the demand for those expiring in 23 to 37 DTE which VIX is based on. Contracting demand while keeping supply same silences the VIX.
THE VIX AND REALISED VOLATILITY
In theory, realised & implied volatility (VIX) should be at similar levels and move in tandem. However, in practice where greed & fear trump rationality, VIX overshoots realised volatility.
Over the last ten years, VIX on average is 307 bps higher than 30-day rolling realised volatility. The spread between the two at 40 bps is narrow as of this writing, making options buying relatively cheap.
MACROFORCES BUT MICRO IMPACT ON VIX AND OUTLOOK FOR 2023
How does VIX respond to rising rates, contracting Fed Balance Sheet, and geo-political shocks?
VIX should be sensitive to rate changes & Fed Balance Sheet shifts given tight interdependencies. However, it turns out that it is not as sensitive to these macro metrics.
The chart below shows that VIX spiked nearly 400% in March 2020 when Fed hammered rates to zero while massively expanding its balance sheet to fend off pandemic-linked economic collapse. A similar trend was observed in 2008.
Notably, VIX did not spike when Fed started to hike rates in 2022. Steady shifts have much lesser impact on it when compared to radical shifts that shocks the system. Chart below highlights key events that sent VIX soaring.
Large VIX moves are driven by shocks. Periods of high volatility as observed last year are caused by market uncertainty over a longer period.
A radical shift in monetary policy – like the one in 2018 – will send VIX higher. Back then, it jumped on fears of Fed hiking rates. Now, a change in the rate regime could push up the index.
A tailwind to VIX is the on-going conflict between Russia and Ukraine. Any escalation could bump it up to levels unseen in the recent past.
TECHNICALS POINT TO A REBOUND IN VIX
Mean-reversion is common in financial markets. It is the tendency of asset prices to revert to its longer-term average.
Since last November, VIX has been trading below its 200-day moving average (200 DMA). It could rise beyond the 200 DMA as it reverts to the mean.
EXPLOITING VIX MEAN-REVERSION WITH CME MICRO E-MINI S&P 500 OPTIONS
Bullish VIX? Long VIX futures? Perhaps not. Why?
Given rising growth in shorter dated options, VIX remains bottled-up. Jumps in extremely shorter-term volatilities fail to show up in it.
Therefore, instead of VIX futures, this case study features a long straddle using CME’s Micro E-Mini S&P 500 Options to deliver a compelling and comprehensive return profile gaining from both volatility expansion and price action.
The long straddle is designed to deliver profits when the index makes a sharp move either up or down while also gaining from volatility expansion.
Straddles are usually considered expensive as it requires two upfront premiums. However, with VIX below its 200 DMA and near the 30-day-rolling historical volatility, these premiums are relatively cheaper.
A long straddle generates returns when (a) underlying futures trade past break-even points, and (b) volatility expands. As expiry inches closer, the straddle loses value which requires close monitoring.
CME offers a wide range of options on deeply liquid S&P 500 futures. To meet growing demand for shorter-dated expiries, CME is expanding the listing cycle of Micro E-mini Options on Micro E-mini NASDAQ and Micro E-mini S&P with expiries available throughout the week, on every business day.
These ultra-short, or same-day expiries can be used to reduce straddle cost further enriching returns from this strategy.
Also, investors can fine tune their hedging & trading with shorter expiries and smaller notional values. At 1/10th the size of the E-Mini contracts, Micro E-mini Options require less capital to enter the market with more approachable margins for short positions.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/gopro/
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
REFERENCES
www.cmegroup.com/mar...ctSpecs.options.html
www.cmegroup.com/tra...-e-mini-options.html
As mentioned in our previous papers, current times are unprecedented, from geo-politics tensions, restrictive monetary policies, fractured corporate earnings, to sticky inflation. the VIX should be anything but sanguine. Any mild escalation could send equities tanking or soaring at the sight of relief.
When the road ahead is that uncertain, straddle saves the day. This case study argues for a long straddle in CME’s Micro E-Mini S&P 500 Options to gain from price action and from rising volatility.
Low VIX plus narrow spread between VIX & realised volatility reduces straddle cost. Large price action plus volatility expansion will deliver a compelling 1.25x reward to risk ratio.
DEMYSTIFYING VIX
Volatility Index ("VIX") is also known as the Fear Index. Higher the fear, greater the VIX. Typically, VIX above 30 points to elevated uncertainty. VIX below 20 describes stable markets.
VIX is market’s expectations of S&P 500 Index (SPX) volatility over the next 30 days. It is computed by using the weighted prices of SPX options across a range of strikes expiring within the next 23 to 37 days. It is an annualised quantifiable measure of market uncertainty.
Volatility is inversely proportional to the square root of time. A year comprises of 252 trading days. Dividing VIX by the square root of 252 (~16) provides daily expected moves. Current VIX at 20.7% implies ~1.3% daily move.
IS THE VIX BROKEN?
Several threats loom yet VIX remains subdued. Is it broken?
In a recent FT Alpha Ville column, journalist Robin Wigglesworth postulated that the VIX may not be broken. Instead, it has been diluted by product innovation resulting in risk pricing windows shifting away from VIX’s target expiry range.
Growth in short-dated options (including zero days-to-expiry or 0DTE options) has shrunk the demand for those expiring in 23 to 37 DTE which VIX is based on. Contracting demand while keeping supply same silences the VIX.
THE VIX AND REALISED VOLATILITY
In theory, realised & implied volatility (VIX) should be at similar levels and move in tandem. However, in practice where greed & fear trump rationality, VIX overshoots realised volatility.
Over the last ten years, VIX on average is 307 bps higher than 30-day rolling realised volatility. The spread between the two at 40 bps is narrow as of this writing, making options buying relatively cheap.
MACROFORCES BUT MICRO IMPACT ON VIX AND OUTLOOK FOR 2023
How does VIX respond to rising rates, contracting Fed Balance Sheet, and geo-political shocks?
VIX should be sensitive to rate changes & Fed Balance Sheet shifts given tight interdependencies. However, it turns out that it is not as sensitive to these macro metrics.
The chart below shows that VIX spiked nearly 400% in March 2020 when Fed hammered rates to zero while massively expanding its balance sheet to fend off pandemic-linked economic collapse. A similar trend was observed in 2008.
Notably, VIX did not spike when Fed started to hike rates in 2022. Steady shifts have much lesser impact on it when compared to radical shifts that shocks the system. Chart below highlights key events that sent VIX soaring.
Large VIX moves are driven by shocks. Periods of high volatility as observed last year are caused by market uncertainty over a longer period.
A radical shift in monetary policy – like the one in 2018 – will send VIX higher. Back then, it jumped on fears of Fed hiking rates. Now, a change in the rate regime could push up the index.
A tailwind to VIX is the on-going conflict between Russia and Ukraine. Any escalation could bump it up to levels unseen in the recent past.
TECHNICALS POINT TO A REBOUND IN VIX
Mean-reversion is common in financial markets. It is the tendency of asset prices to revert to its longer-term average.
Since last November, VIX has been trading below its 200-day moving average (200 DMA). It could rise beyond the 200 DMA as it reverts to the mean.
EXPLOITING VIX MEAN-REVERSION WITH CME MICRO E-MINI S&P 500 OPTIONS
Bullish VIX? Long VIX futures? Perhaps not. Why?
Given rising growth in shorter dated options, VIX remains bottled-up. Jumps in extremely shorter-term volatilities fail to show up in it.
Therefore, instead of VIX futures, this case study features a long straddle using CME’s Micro E-Mini S&P 500 Options to deliver a compelling and comprehensive return profile gaining from both volatility expansion and price action.
The long straddle is designed to deliver profits when the index makes a sharp move either up or down while also gaining from volatility expansion.
Straddles are usually considered expensive as it requires two upfront premiums. However, with VIX below its 200 DMA and near the 30-day-rolling historical volatility, these premiums are relatively cheaper.
- Leg 1: Long 4150 Call on MESM3 (expiring in June 23); premium of 171.25 index points
- Leg 2: Long 4150 Put on MESM3 (expiring in June 23); premium of 185.50 index points
- Premium: $1,800 ((171.25 + 185.50) * $5 = 356.75 * 5 = 1,783.75; ~$1,800)
*Note: 1 point move in MESM3 = $5
- Break-even points: S&P 500 futures at either 3790 or 4510
- Target: S&P 500 futures at either 4600 or 3700
- Profit at Target: $450
- Stop-loss: At 20% of the drop in options premium
- Loss at Stop-loss: $360
A long straddle generates returns when (a) underlying futures trade past break-even points, and (b) volatility expands. As expiry inches closer, the straddle loses value which requires close monitoring.
CME offers a wide range of options on deeply liquid S&P 500 futures. To meet growing demand for shorter-dated expiries, CME is expanding the listing cycle of Micro E-mini Options on Micro E-mini NASDAQ and Micro E-mini S&P with expiries available throughout the week, on every business day.
These ultra-short, or same-day expiries can be used to reduce straddle cost further enriching returns from this strategy.
Also, investors can fine tune their hedging & trading with shorter expiries and smaller notional values. At 1/10th the size of the E-Mini contracts, Micro E-mini Options require less capital to enter the market with more approachable margins for short positions.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/gopro/
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
REFERENCES
www.cmegroup.com/mar...ctSpecs.options.html
www.cmegroup.com/tra...-e-mini-options.html
Trade closed: stop reached:
As of settlement on 27 March 2023, the value of the options straddle (Strike Price: $4,150) expiring in June 2023 is $1,407 ($211.5 + $70).
Given the entry level, the value of the straddle results in a loss of $393.
This brings the premium level below the stated stop loss level of $1,440.
Given the entry level, the value of the straddle results in a loss of $393.
This brings the premium level below the stated stop loss level of $1,440.
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