This VIX Is Giving Me Deja Vu!

The Option Pit VIX Traffic Light is Yellow: Volatility Will Move Wildly.

Hey Traders,

I don’t know about you, but I am starting to get deja vu …

We saw Tuesday’s session open with the S&P 500 down, and the VIX up …

Is anyone else getting flashbacks to last week, or is it just me?

The Option Pit VIX Traffic Light is now yellow, indicating that we will see volatility make a move in one direction or the other.

I think I know which way it will head next …

So what am I watching, and how would I trade it?

Before today’s sudden VIX spike, VIX futures were holding a nice contango pattern (meaning futures were trading higher than cash VIX).

What’s more, near-term VIX futures were actually trading at quite a premium to the VIX itself …

The October futures themselves were pricey, and the November futures were even pricer, relative to October … 

Today, the VIX curve looks quite different …

The curve is now in backwardation, with VIX spot price actually trading at a premium to VIX futures … 

This is similar to what we saw last week. 

This was enough to trigger the Option Pit VIX Light to switch to yellow.

Remember, I warned that situations like this could last for a few weeks …

First we’d see a sell-off (which we did) …

Then a rally (which we did) …

Followed by a second sell-off (which we are seeing now) …

Before finally the S&P 500 (Ticker: SPX) continues its bull run.

I do not think this will be a long-term sell-off in the SPX, and therefore a long-term spike in the VIX.

Here is why …

After last week’s drop-and-pop, we did see an uptick in realized volatility in the SPX. 

(As a reminder, realized volatility is volatility that has already happened, while the VIX measures implied volatility, which looks ahead at what traders think will happen in the future.)

The white line is the 10-day historical volatility (HV) of the SPX, and the blue line is the 20-day HV.

But, even as dramatic as that vol spike looks, HV still did not reach anywhere near the same levels as the VIX.

The VIX got as high as 28 …

Meanwhile realized volatility flew all the way up to … 15.

Why is this happening?

Simply put, the market is over-hedged, which is making it hard to see a real sell-off.

I said last week that if you are looking to go short on vol, you want to wait until the VIX hits its lower high during the second pullback …

Well, we have arrived.

I am liking the October 18-strike puts.

However, I do think we could see a little more uptick in the VIX before we start to turn around.

So as a very short-term play, I am looking at the Oct.1 iPath Series B S&P 500 VIX Short-Term Futures ETN (Ticker: VXX) 27-strike put and 28-strike call strangle. Right now, you can get into this trade for about $2.15.

I also like the VIX October 25/27.50/50-strike call fly as a hedge.

Your Only Option,

Mark Sebastian

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