Trading VIX Around the Upcoming Debt Ceiling Debate

With another debt ceiling debate looming just around the corner, many volatility traders ask "How do I play this event?"

Well to answer that question I like to first figure out where VIX is trading. Currently:

  • VIX sits at 14.42 (currently +9.9% on the day)
  • Actual volatility of the S&P 500 over the past  month (HV20) is at 11.50, 
  • Actual volatility over the past 3 months (HV60) is 9.58. 

These values tell us that a VIX of 14.42 is actually high given the amount of volatility that the market is actually experiencing -- VIX is at a 25% premium to HV20 and a 50% premium to HV60. The market is already expecting a greater amount of volatility in the next month compared to what we have experienced in the past 3 months.

The recent rise in VIX to 17 in late August was for the most part attributed to the events in Syria. Once was a diplomatic solution was "found" VIX began to retreat to normal levels. As you can see by the green circles in the graph below, VIX tends to fall toward the "floor" set by HV60. With HV60 currently below 10 and VIX at 14.39 there is still a long ways to fall (33%). However, just because the floor is down below 10 doesn't mean that it'll necessarily make it down there.  HV20 is on the rise, moving from 6.49 in early August to above 11 today, an indication that the market as a whole is growing more volatile.

An interesting point in the chart above is 8/30/13 (see red rectangle) when the value of front month VIX futures (M1) was 17.5 and HV20 was 9.58, an 83% premium. It is rare for front month VIX to be above 17 while HV20 is below 10. In fact, in the past nine years this has only happened a handful of times (7/2004, 12/2009, 3/2010, 11-12/2010, 1/2011, 4/2011, 2/2012, 8/2012, 12/2012). In most instances M1 and HV20 converge towards each other over the next 3-6 weeks then rise rapidly together as VIX and actual volatility spike. We'll soon find out if the 8/30/2013 instance follows a similar pattern.

But given that VIX is trading at a premium to actual volatility and VIX futures are in contango, the expectation is that VIX and VIX futures will continue to fall. That means the "correct" long-term play as of now, due to the structure of VIX ETPs, is to continue to short volatility both for near-term VIX futures (long SVXY/XIV or short VXX/TVIX/UVXY) and medium-term VIX futures (ZIV), although I believe that smaller positions are warranted given the compression in the VIX futures curve.

Now that we've taken a look at the technical side, let's get back to the question about the debt ceiling.

We've been through several rounds of debt ceiling political theater weighing on the stock market. After a few rounds of debt ceiling and sequester deadlines in the past 2 years the market seems to be getting used to the sequence of events, complete with a last minute deal to once again kick the can into the future.

One idea of how to play the Sept/Oct 2013 episode is to wait for a VIX spike that occurs in the final hours of negotiation just before the deadline and short volatility. History gives us some positive data that this could be a good play. However, this strategy depends on several points:

1) Will market participants fret enough to cause a rise in VIX in advance of the event?

  • In the July 2011 episode VIX ranged between 15 and 21. In Nov/Dec 2012 VIX ranged between 15 and 19.6. After hitting 12.52 last Friday, VIX is now at 14.32 with just one week left for congress to pass a "Continued Resolution" to continue spending after Sept 30th, and several weeks until all extraordinary measures to continue spending have been exhausted by the Treasury. Not only is the market not worried about this, but there's not even the infamous "countdown clocks" on the major media stations. I think you have to assume it will be political grandstanding business as usual and implied volatility will rise over the next several weeks, but it is not clear if this will happen as a gradual build up to the event, or more quickly just as the event is about to occur. Being long VXX over the next few weeks could be difficult given the "headwind" it faces due to the contango term structure. 

2) Will a deal get done?

  • I think the answer is yes and I believe the market believes the answer is yes. Whenever this happens, the immediate reaction will most likely be positive and make for a very good short volatility play (assuming there is a build up in VIX leading up to it). 

3) Will a market-positive deal get done?

  • Given the ratings downgrade and sell off after the July 2011 episode, this question should be of concern to investors as well. While a deal is likely to get done, investors will be looking at the "cost" of the deal. The details of  the deal, as well as the manner in which it is achieved, are just as important as the deal getting done in the first place. This will remain an unknown until it happens but is something to keep an eye on after the immediate reaction.
I prefer to take the information one day at a time to see how this episode plays out, closely watching for any significant changes to the VIX futures term structure and ensuring I have appropriate stops in place. The biases remain positive for SVXY, XIV and ZIV and negative for VXX, TVIX, and UVXY so I like to use those to my advantage while they exist.

Also remember that some periods of trading are easier than others. A directional move is easier to trade and more profitable than a choppy market, and you have to expect that the market over the coming weeks will be choppy and event-driven. There is a good case to be made to avoid this period altogether and wait for the "easy" money to be made once a new direction has been established.

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Update To VXX Spike Risk Forecast Algorithm

Today we made an update to our algorithm for the VXX Spike Risk forecast. The change is designed to refine the forecasts to provide increased accuracy.

The forecasts now estimate the probability of a spike in VXX of 7% or more (previously 8% or more) for the next 2 days (previously 3 days). The changes results in:
  • An overall lower spike probability for most days (due to the shorter prediction period)
  • An increased spike probability when spike conditions are present (due to a lower spike definition threshold)

See below for before and after graphs of the forecasted results over the past 6 months.

No changes were made to any of the Bias forecast calculations.

Before changes:

After changes [updated 9/18/13]:

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Free Membership Winners

Thank you again to everyone for supporting Trading Volatility last week in our 100,000th visit celebration. The winners of the one free month memberships to Trading Volatility+ are:

Current Members


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Celebrating 100,000 Visits To Trading Volatility With Free Memberships

The mission here at Trading Volatility has always been to help those interested in trading volatility ETFs to be more successful by providing the data analysis tools and education in order to demystify these complex products.

We have made good progress in our ability to reach people and are extremely excited to celebrate our 100,000th visit to Trading Volatility this week. To show our sincere gratitude to everyone who has supported us, we will be removing the one week delay on the VIX Futures Data and Daily Forecasts portions of the site for the remainder of this week.

Also as part of the celebration we will also be giving away five 1-month memberships to the Trading Volatility+ subscriber site.
  • Three 1-month memberships will be given away to current non-members
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I am thrilled that we have been able to help so many people sort through the complexities of volatility funds and look forward to reaching our next milestone together.

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