Spread It Out on the VIX Drop

The Option Pit VIX Light Is Red, and Volatility Will Drop.

Hey Traders,

The VIX did its normal thing on Monday — it rose marginally.

But we could really see what was happening in the VIX futures, which shifted week-over-week:

The front two futures dropped week-over-week, although May and June did NOT drop as much as the previous week’s future curve would have predicted.

If it had dropped as expected, those blue dots would literally be ON the purple line from last week.

Interestingly we saw a rise in VIX futures in the back months, with July on rising a touch.

As it stands now, this curve is going to put downside pressure on iPath S&P 500 VIX Short-Term Futures ETN (VXX), although, remember, if the VIX futures don’t move, neither will VXX.

VXX, as it stands, should, all other things equal, lose a little more than .25 cents per day.

One of the great things about the recent VXX reverse split is that …

While the percentage drop it loses per day is the same as pre-split, the raw dollar drop is much bigger.

With May options having 24 days to expire as of Tuesday, it means the VXX is set to lose more than $5 between now and May expiration …

Yet, the May 39 puts only cost about 2.75.

My Trade

Knowing VXX is likely to drop by about $5 (I usually like to discount a few cents for the invariable up and down movements), I like to reduce the cost of the puts I buy, by selling a further out-of-the-money put — thereby creating a put spread.

Yesterday, the trade I sent out to the Vol Edge clients was to buy the 39 puts and sell the 35 puts, paying about 1.90.

This means I am betting 1.90 to make $2.10 … on an instrument that costs $4 — but has a $5 dollar headwind on it.

You can see the payoff here:

I ended up paying 1.95 (I have to wait to trade until AFTER we send out my trade idea to my subscribers) …

And I expect this trade to make a minimum 50% return over the next two weeks.

If VIX rises, I will be hedging using VIX calls, rather than dumping the position.

The Option Pit VIX Light Is Red, and Volatility Will Drop.

Your Only Option,

Mark Sebastian

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