VIX spot is above 14 this morning, mostly due to the weekend effect (Oct VIX futures are only up about 0.15 point). The VIX is in the low teens once again after a precipitous fall following the Fed Non-Taper last week. Now if you look at realized volatility in the SPX index over the past 3 months, even 14 seems high for the VIX. This is the chart of 10 day realized volatility in the SPX, with the 14 level marked in red:
The SPX has not realized over 14 since the market bottomed in late June. Sure, a good part of that has been during the quiet summer months. But as I noted last week, September has been a month of unusually low volatility.
So that’s what has occurred. But markets are always forward looking. The government budget debate that is just getting started has a different set of circumstances this time around. The Republican led House has tied extension of the debt ceiling and a any budget deal to defunding of the Affordable Care Act. This is never going to happen for a number of reasons including the last election. So, the disincentives for getting a budget deal done are much greater today than they were a few weeks ago. Why now?
Check out this post from the capitalgainsandgames blog. Here is the money quote:
That leaves a crisis, and baring a military or foreign policy disaster, the only one with the potential to create enough political pain in a relatively short period of time is a federal shutdown.
That makes a shutdown a better option for Boehner, Cantor, McConnell and Reid than it might otherwise seem.
A shutdown also may work for Boehner because (1) it will show his tea partiers that he was willing to allow it to happen as they wanted, (2) it will change the politics as many voters go from being amused to being furious and (3) the tea partiers may be able to use the shutdown with their own voters to prove their political testosterone.
Is it possible that we get to the brink on September 30 at 11 pm and everyone decides that a short-term CR and a cooling off period is needed? Absolutely. Is it as likely this year as it has been in the past? Absolutely not.
In this context, the VIX at 14 all of a sudden seems far too low. Even the Oct VIX future around 15.25 is likely underpriced. But the best part about our VIX trade is the risk/reward proposition. We can give up the downside in the VIX below 14, and get the upside between 16 and 19, for no upfront premium. We’ll take that risk/reward.
TRADE: Sold the VIX (14.30) Oct 14 Put to Buy the Oct 16/19 Call Spread for Even Money
-Sold 1 VIX Oct 14 Put at 0.45
-Bought 1 Oct 16 Call for 0.95
-Sold 1 Oct 19 call at 0.50
Break-Even on Oct Expiration:
-Profits up to 3.00 between 16 and 19, max profit of 3.00 at 19 or above
-No profit or loss between 14 and 16, structure expires
-Losses below 14 in linear fashion
Though this structure is almost identical to the Sept VIX trade we did that expired for flat, the rationale is different. We were comfortable selling that Sept 14 put because the Fed meeting would be after VIX expiry. In this case, we are comfortable selling the Oct 14 put because we do not plan to remain in the trade until a Congressional bargain is reached. Rather, we plan to buy the rumor of a shutdown, and sell before any potential news or resolution on that front. In short, we think a shutdown possibility is currently underpriced by the VIX market. Even if we’re wrong, we have all week to likely exit for only a small loss. If we’re right though, we’ll likely have a nice gain on our hands.