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A Complex Spread That Gives You 10% Returns in Just One Month

If there’s any super obvious theme in the markets right now, it’s the rotation out of risk.

This means small cap stocks have been underperforming the market and have the potential to make a longer term top.

It’s Getting Ugly

A look at the Russell 2000 shows how much damage has been done:

rut

After an attempt to stabilize around 1160, sellers stepped up aggressively on Friday and we have seen continuation to the downside.

Is this a long term top?

I don’t know.

I trade options that are a month or two out, so I don’t have to worry too much about it.

But since the Russell has been selling of so hard, investors are getting scared and bidding up the implied volatility in RUT options.

And most of the demand has been on out of the money puts as investors fear extreme downside rather than moderate downside.

Taking the other side of this trade is what I want to do.

The Trade Setup

Buy to Open RUT Oct 1090 Put

Sell to Open 2x RUT Oct 1080 Put

Buy to Open RUT Oct 1060 PUt

Credit: 1.10

This trade is a broken wing butterfly. It’s called “broken” because the distance between the long strikes are not the same. This helps to bias the trade so you can collect a credit on a move higher.

rut-risk

The Risk and Reward

This trade makes money a few ways:

1. If the RUT rallies
2. If the RUT sells off slowly
3. If the RVX goes lower
4. If the option skew goes lower

Given how far we’ve sold off already, all of these seem like good odds.

The major risk here is if the RUT sells off aggressively. The downside breakeven at options expiration is 1070, which would require another 50 point selloff in the RUT. This is unlikely, but possible.

The maximum capital required in this trade is $890.

If RUT rallies you keep the credit of $110, giving you a return on risk of about 12%.

If RUT continues lower but settles around 1080, you can see outsized returns, but the odds of that are very low.

If you want to see how we do this in real time, get a 2-week pass to IWO Premium for $14. Trade alerts, nightly videos, video training, and a chat room. Get the pass here.

This Top is Obvious, and Investors Are Already Overhedged

Have a look at this 30 minute chart of the QQQ (Nasdaq 100):

qqq-top

After a hard rally in August, the Nasdaq has been in a time-based correction.

And it looks like a top, right? Feels like a top?

Ready to rollover?

Here’s the problem with that thesis. This is a 30 minute chart of the VXN, which is the VIX for the Nasdaq:

vxn-30

THe normal relationship with markets and options is that options will become in high demand when markets are selling off as investors are fearful that the current selloff will continue.

What we have here is a unique situation where there are many investors buying protection in anticipation of a selloff that hasn’t occurred.

If the VXN were near 3 month lows I would be convinced that further downside is coming in the markets.

But because eveyone and their mother has already positioned for that pullback, this turns it into a bullish case.

My guess is that we will break under the “obvious” support level, suck in some more shorts and put buyers, then reverse higher and retest the range highs.

The Two Magnets in the S&P

In my member’s video last night, I laid out in very clear terms that 2 things will most likely happen:

1. The SPX will bounce this week

2. It won’t be the bottom.

Of course these claims are not set in stone as anything can happen, but given the way the market has traded pullbacks for the past few years, this is the highest odds play.

But these claims lead to questions… where will the bounce stop and where will the bottom be?

One of the cool things about technical analysis is recognizing that certain levels will act as magnets.

That these levels are so overwatched, price will move to those levels just to see if it is accepted or rejected.

There are two of these “magnet” levels right now for the S&P: 1900 and 1950.

spx

1900 is previous resistance from the Mar-May base and the 38.2% fib retracement from the Feb lows to the recent highs.

1950 is previous support from the July top and the 50% retracement from the current lows to the July highs.

The market thesis is this:

If the SPX does bounce but fails to retake 1950 within the next two weeks, we will go and test 1900.

With this thesis, the gameplan now is:

1. If we flush into 1900 in short order, load up on bull put spreads.

2. If we rally into 1930-1950, take long risk off and buy some SPX hedges– 1900 put butterflies are a great trade.

3. Odds are we fart around in this range for a bit (provided no news catalysts) and IV is high so iron condors work here.

If you want to see how we do this in real time, get a 2-week pass to IWO Premium. Trade alerts, nightly videos, video training, and a chat room. Get the pass here.

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So You Want to Buy the VIX…

At the time of this writing, the VIX is at 11.15.

It’s low.

Hilariously low.

And with so many talking about the death of volatility (which isn’t true) you might want to take a contrarian bet and get long the VIX.

So you open up your brokerage account, pull up the VIX, and place a buy order.

You’ll probably see this pop up:

vix-not-tradeable

Well that’s not good. It turns out, the VIX is a non-tradeable statistic, derived from SPX options pricing.

What do you do now?

You could trade VX futures! Let’s have a look at the current prices:

vx-futures

You could buy the June VX future for 12.24, but those only trade for one more week and converge on the spot VIX. If nothing happens you could see a buy of 12.24 drop all the way to 11.

Instead you could buy July VX futures… for a higher price. Because more bad stuff can happen in a month. The more time to expiration, the higher the cost. In fact, buying a July VX future at 13.50 isn’t the best deal in the world because we haven’t traded above 14 in 2 months.

So you move on to VIX options… except the underlying of VIX options isn’t the VIX, it’s the expected value of what the VIX will be in the future, as reflected in VIX options.

Maybe buying a July 12 call for 1.75 is a good bet (which I think it is)– so if the VIX pops, you’ll see a move.

Here’s the problem with that– if and when the VIX does move to the upside, the VX futures (and the corresponding gain in the options) will be dampened because much of that will have already been priced in.

If the July VX future is at 13.47 and the VIX pops up to 16, that doesn’t mean the future will pop up 5 points as well… the futures market may in fact trade at a discount to the spot VIX, which often happens during market pullbacks.

You could then look to vol ETP’s like VXX and TVIX, but those come with roll yield issues and structural inefficincies.

And so on.

The point here is not that long volatility is a bad trade– in many cases long vol is a great trade here.

But thinking you can just get long the VIX because it hit 11 is a much more complicated idea than what it seems.