As summer quickly approaches, it seems there are many traders who feel volatility is going to vanish in the coming months. It’s not unusual for volatility to diminish in the summer. However, there appears to be even more bets than usual that the market is going to remain calm.
Market volatility these days feels a lot like it did in 2017. It was one of the least volatile years on record. Will 2019 be a repeat of 2017? The Mueller Report is now out in the open (mostly) and the Fed has essentially pledged to keep interest rates low. It certainly doesn’t seem like there’s a lot of volatility-spiking events on the horizon.
Still, you never quite know with volatility. A couple poor earnings results combined with some negative economic data could change the market’s tune in a hurry. Once again though, it seems like an unlikely scenario at this point.
Probably the most popular way to trade volatility is through iPath S&P 500 VIX Short-Term Futures ETN (VXXB). VXXB tracks the first two futures months of the VIX (the S&P 500 volatility index), so is a very good gauge of short-term volatility. As an ETN, it trades like a stock, making it easy for anyone with a brokerage account to trade.
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Options on VXXB are also extremely active. The average options volume for the ETN is over 100,000 but on busy days it can trade hundreds of thousands of contracts quite easily. It’s a good example of a product traded actively by both institutional and retail traders.
Getting back to the volatility environment, a big trader is making a risk-controlled bet that VXXB will continue to plummet into the start of summer. Specifically, the trader purchased the June 20-21 put spread with VXXB at $26.22. That means the 21 put was purchased (for $0.29) while the 20 put was sold (for $0.12). The total premium cost of the trade was $0.17.
So you may be wondering, why do just a 1-strike spread? And, why sell the 20 put in the first place, which only offsets the cost of the 21 put by 12 cents? Let’s do some math to help explain.
The trader bought this spread 12,238 times. That means the 17-cent spread actually cost over $208,000 in premium. Had the trader just bought the 21 puts for $0.29, it would have cost $355,000. By selling the 20 put (against the 21 put) the cost of the position was cut by 41%. That may not mean much when you’re talking about a 1-lot, but when you do over 10,000 spreads, it certainly adds up.
From a percentage standpoint, this trade can also generate really nice profits. If VXXB drops below $20 by expiration, the spread is worth $0.83 to the buyer. That’s a million dollars in profit or a 488% return.
You can see why a 1-strike spread can really pay off. The buyer is only on the hook for 17 cents per option but can earn 83 cents. Now, $0.17 times 12,000 spreads is still a lot of money. However, the upside potential is quite large in comparison to the risk taken.
This is also quite an easy to trade to emulate if you believe volatility will continue on its downward path. For $0.17 you get roughly a 2-month trade that is low risk (due to the low cost) but still has high upside potential. Volatility would need to basically vanish from the markets for this trade to work, but it certainly wouldn’t be the first time for the scenario to occur over the last few years.