There’s a famous Monty Python skit from the 70’s where, out of nowhere, three men dressed up like medieval Catholic priests jump into a room shouting “Nobody expects the Spanish Inquisition!”. Of course it was very much in line with the sort of random and absurd humor Monty Python is famous for.
I tend to think of this skit anytime something completely unexpected happens in the financial markets. I imagine the same priests jumping onto a trading floor shouting about the Spanish Inquisition while surprised traders freeze in the middle of whatever they were doing. (It really helps add levity to situation where the surprise is costing you money.)
I had one of these “Spanish Inquisition” moments this week when market volatility (as seen through the VIX) shot up to its highest level in half a year. Earnings and economics news had been good to very good prior to the volatility spike. Additionally, there weren’t any significant, short-term macro events which may have had investors on edge.
It basically came out of nowhere.
Sometimes, an unexpected volatility spike can mean a reversal in the direction of the market. I’m sure some investors are starting to believe a stock market correction is coming. Personally, I don’t think that’s the case.
By the time you read this article, it’s very possible volatility levels will have come back down to more “normal” levels. The VIX and volatility definitely have their share of spikes – but mostly, volatility goes down very soon after those spikes.
There are definitely traders and investors out there buying loads of volatility for protection – through the VIX or other volatility products. However, there are also plenty of traders using this opportunity to take a short position on volatility (particular in the short-term).
One of the most popular ways to trade volatility is through iPath S&P 500 VIX Short-term Futures ETN (NYSE: VXX) which tracks the nearest two months of VIX futures. VXX has been quite active, as expected, with volatility getting a nice bump lately.
Here’s one trade that stood out to me which makes money if volatility reverts back to lower levels…
With VXX around $30.50, someone purchased 500 February 16th VXX 26-27 put spreads for $0.24. That means the buyer is risking $12,000 (premium costs) in a bet that VXX will get back down to $26 in two weeks. If so, the trader will make $38,000 in profits.
These narrow put spreads can be sneaky good trades. Many casual options traders don’t realize that big profits can still be made in $1 or $2 wide debit spreads. However, this sort of trade is used by pro options traders quite often.
Just look at the risk/reward of this particular trade. For $0.24 you have a chance to make $0.76. That’s over 200% profit. And, you have two weeks for this trade to work – which is a long time in terms of volatility. In fact, VXX could be back at $27 in two days, forget two weeks.
Of course I can’t predict the future, but I definitely like this trade and highly recommend it or something similar. I’ve also included a link to me making this actual trade in my account, so you can see how it’s done!
I’ve put together a short training video showing exactly how to execute this trade. If you have a moment check it out. Click here.