The VIX has a highly negative correlation to the SPX. The VIX is priced upon the time value that is embedded in the premium of SPX options. When stocks fall they usually move much more rapidly to the downside than they move to the upside. As the stocks fall investors rush to scoop up puts that provide downside protection or grabbing calls should there be a correction. Insurance for a beachside cottage is much more expensive when a hurricane hits ten miles offshore than when there hasn’t been a hurricane in ten years. The same principle applies to the stock market.
Let’s look at some situations that can be viewed as the calm before the storm. On August 22nd of 2014 the VIX closed at 11.47, its low for the day. In less than two months, on October 15th, the VIX closed at 25.27 with an intraday high of 31.06. Less than two months later, on December 5th, the VIX closed at 11.89 with an intraday low of 11.53. Less than two weeks later, on December 16th, the VIX closed at 23.57 with an intraday high of 25.20.
Let’s take a look at some data that reflects the recent action of the VIX and the SPX.
On July 9th the VIX closed at 19.97, near its high for the day of 20.05. On July 8th and 9th the market bottomed out due to the worries about China and Greece. A little more than a week later, on July 17th, the VIX closed at 11.95, its low for 2015. On the 17th each succeeding futures contract is higher than the preceding one and much higher than the spot VIX. Traders believed that the VIX would not stay at such a low level. On the 8th and 9th all of the futures contracts were very closely bunched together and they were priced less than the spot VIX. Traders did not believe that the VIX was likely to stay at that high a level.
There is no vehicle to trade options on the spot VIX. The next best thing is to trade the VIX options. They are cash settled but their pricing is based upon the price of the VIX futures. The VIX closed at 12.25 on July 20th. The VIX futures closed at 14.30. The Aug 14 VIX calls were offered at 1.35. That means that the breakeven point is 15.35. The maximum loss is 1.35. The VIX Aug 19 calls are bid at 0.50. You can create a vertical spread that lowers the breakeven point to 14.85 and reduces the maximum loss to 0.85. You give away your chance for the home run, should the VIX truly explode but that doesn’t happen too often. Here is a graph of the VIX Aug 14-19 bull spread 10X:
The maximum possible profit is $4,150 at 19 or higher. The maximum possible loss is 850 at 14 or lower. If the spread is taken off before expiration a profit of $2,000 could be achieved if the futures trade around 19.