VIX Drops Below 37. Time to Buy or Sell Vega?

The market has been soaring, and the S&P 500 index is > 28% higher than it was at its recent 12-year low.  Most of time, rising markets are accompanied by a decline in VIX, the CBOE volatility index.  As we've mentionedpreviously, this rally was not always accompanied by a declining VIX. Indeed, VIX rose on some strong days for the stock market. But this week, VIX broke decisively through the 40 level.

This VIX decline presents a profitable opportunity for option traders, but we won't know until later which of two paths to take.  Obviously you can continue as you have been, and ignore this VIX decline.

But, if you want to get involved, there are two opportunities:

1) Assume the VIX breakdown will continue and that VIX will decline further.  That suggests two tradable events: either the market will move higher; and/or VIX is correct in predicting that the near-term will see a less volatile market.  I'm not willing to play this one, but the game would be opening new iron condors (which profit when implied volatility decreases).  If you care to trust the VIX breakout to the downside, you can open those ICs with a slight bullish bias.

I just cannot bring myself to get bullish here (stubbornness), so that's not for me. But, is it for you?

2) The alternative is to accept this VIX decline as an opportunity to own vega.  That can be done by opening double diagonal spreads or by adding calendar spreads to your portfolio. You may even decide this presents an opportunity to add some relatively inexpensive (compared with recent history) insurance, by buying strangles to protect your portfolio.

A more conservative approach is to only open new iron condors in the front-month or two.  If you are like me, you prefer to open iron condors with more time to expiration.  A reduced volatility market is not the right time to trade longer-term spreads.  Thus, one way to play this VIX breakdown is to avoid 3- and 4-month iron condors.

Be aware that if you choose double diagonals, and if implied volatility declines further, you won't have much chance to earn a profit.

It's not necessary to take advantage of every opportunity that presents itself, but IV is lower than it has been for awhile, and each of us must decide whether to buy vega, or trade positions as we usually do.  A reasonable compromise is to postpone this decision for a few days and see what tomorrow brings.

Addendum 4/13 10:40 AM

Bill, at VIX and More discusses the same issue today: Is VIX high or low?

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4 Responses to VIX Drops Below 37. Time to Buy or Sell Vega?

  1. volramp 04/13/2009 at 10:38 AM #

    Dear Mark
    Sorry to drag you back to the diagonal backspreads, but I have a risk question. In the table that shows the dollar cost of each position, you say that , for example, postion A would cost $2,020. This position has front month 10 short RUT calls strike 460 hedged by back month strike 500. So my broker would “charge” me 40 points (500-460) maximum risk, which translates into $40,000 usage of buying power. What am I missing here? Pls explain. Thnk you.

  2. slait73 04/13/2009 at 2:59 PM #

    HI Mark
    There´s somethig I´m too worried about this lst week end.
    The problem is about holydais or vacation. Could you explain how do you manage the positions when you go out some days?
    With your system If you know you are going on travel for some weeks (and you have no internet) that forces you not open any IC that expires in that dates and the dates after you come back.
    oh, it´s horrible¡¡¡, Is something I just realized¡¡

  3. Mark Wolfinger 04/13/2009 at 8:27 PM #

    I apologize for this reply being out of sequence, but I’ve been having trouble with my blog host.
    I plan to revisit those diagonal back spreads at a later time, so it’s no problem.
    I don’t think you are missing anything.
    The cost of $2,020 refers to the option premium. The purchase of 16 June calls and the sale of 10 May calls results in paying a debit of $2,020. That’s the ‘cost.’
    There is a margin requirement to carry this position in your portfolio.
    In this example, you are short the 40-point spread, and the margin is $4,000 for each, or $40,000 total. In addition, those extra 6 calls must be paid for with cash, using even more of you margin allotment, or buying power.
    But your broker is not ‘charging’ you anything. The broker simply requires you to have assets – cash or marginable securities – in your account to own this position. It really is not a charge. The margin is established in case the spread loses the maximum. The broker wants to be certain you can absorb that loss and still have positive account value. In reality, this spread cannot lose $40,000, but your broker doesn’t care. A 40-point spread requires $4k in margin.
    I hope that helps

  4. Mark Wolfinger 04/13/2009 at 8:34 PM #

    I don’t think it’s that bad, and it is something you can avoid.
    The safest, most conservative, and most prudent policy is to exit all position before you go on vacation. Then there are no worries. There are no profits either, but it sounds to me as if avoiding losses is your major concern.
    If you can plan vacations to occur after an expiration, that makes your trading life easier, but I know that’s not easy to do.
    I take my laptop if I travel, so I don’t have this specific problem. But I’ve had this problem over the years (when I was a market maker) and holding positions when out of touch is not a good idea. It’s just too risky.