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4 Reasons The VIX Isn’t Moving

Since the beginning of the year I've been getting questions about the market through email and social media.

... and to be honest I've had the same question too.

We've had the worst start to the year ever, and things are still looking really sketchy.

Earnings reports are obliterating stocks, Chinese currency risk is still out there, and the Fed is being stubborn about how fast it wants to raise rates.

But during all this time and all this volatility, it feels like the VIX hasn't budged:

vix

After all, we've broken below the August crash lows but the VIX hasn't managed to hold above 30 for any amount of time.

Is this the options market full of "smart money" traders looking for a bounce, or is it extreme complacency in front of the coming abyss?

I've got 4 reasons that explains how the VIX isn't moving as much as we thought.

Investors Are Already Hedged

Once possibility here is that anyone who needed to hedge already did back in August of last year.

After all, we did see massive movement that indicates a bunch of investors were buying puts to protect themselves. If they still have that protection on, they don't need to re-buy their protection, which helps to keep a lid on further upside VIX movement.

The same kind of dynamic occurs with investors who have already sold their stocks. If you're in cash, then you don't really have to worry about buying protection, do you?

We see this often in market pullbacks... where the S&P 500 will make a lower low but the VIX won't because those that needed to hedge... hedged.

This reason is a little weak because of how much time has passed between the August crash and today. If you bought 3 month hedges, then 3 months has already passed and you already need to hedge.

Let's see what else could help explain this....

Volatility Futures Are Already Elevated

Let's take a look at a chart of the near term VIX futures:

vx-futures

We're still lower than what we saw back in August 2015, but not that far away. In fact, there has been plenty of demand in VIX futures compared to the actual VIX itself.

This represents a pretty big shift in how investors buy protection. A few years ago, your best bet would be to buy puts, but in doing so you have other risks involved... time decay the most obvious.

Many institutional players have moved onto the VIX futures market, which doesn't exactly track the spot VIX. So it's possible that the fear is there, but is being shown in other trading instruments... more on that in a second.

Volatility Futures Have Been Backward All Year

One interesting shift in the market has been the volatility futures market when we look at different durations.

I don't want to bog you down in the complexities, but basically a "normal" market is when the VIX futures contract that's closer to expiration has a lower value than longer dated VIX futures.

But since the crash in August, this has been flipped upside down:

contango

This chart from VIXCentral.com shows the relationship between the near term VIX future and the next term VIX future. Above the red line is contango, and below is backwardation.

Most of the time we are above the red line. When we see the volatility markets shift below the red line, it's usually during a very turbulent time in the markets and often indicates a bounce is near.

But something has shifted, and the fear of near term downside has persisted all year. It truly is an extraordinary occurrence.

This is one of those where looking only at the VIX doesn't give you the whole picture. The fear has been there, just not in ways that you think.

The Risk Off Trade Is Hitting Other Places

I have a pet theory on this one, and I'm not sure I can fully prove it but it feels about right.

My guess: investors are burned out on trading volatility.

Think about it, there have been a few times of panic in the markets over the past few years. And if you used VIX options or VIX futures in reaction to that panic, you've looked stupid.

I also think the other side of the trade got burned... that going into August there were way too many people stuck short VIX options and futures. We can see the squeeze by looking at the VVIX, which is the "fear index" for VIX options:

vvix

That move we saw in August was even higher than what we saw back in 2008.

In response to this, I believe that investors moved back to more traditional "risk off" instruments. At the time of this writing, the Yen/Gold/Treasuries risk off trade has seen a massive rally.

Here's Your Edge

If you've been leveraged long FANG stocks, you've probably been smoked and aren't looking forward to the rest of the year.

Same goes to players that have a longer term horizon.

But this increase in volatility is very profitable for option traders.

It means there are higher option premiums, not only on an absolute basis but also with further out of the money options.

Given the right strategies and setups, you can see fast profits in the market... both to the short side and long side.

If you'd like to get my views on the market on a daily basis, as well as receive option trading alerts, then I encourage you to join my trading service. You can get a two week trial for only $14.

Click Here to Join.

The Great Holiday Volatility Crush

crushWelcome to the shakeout.

The investor zeitgeist is currently obsessed with two things:

  1. High yield debt
  2. Fed raising rates

The outcome of the Fed is what we would call a "known unknown."

If you have some magical crystal ball that will tell you exactly what the fed will do and how the market will react to it...

... you probably paid too much for it.

We don't know how the market is going to react to the Fed. The consensus is that Rate Hike = Bad and No Hike = Good-- but how many times have we seen the reaction to the Fed meeting be one giant stop-run, fade and reversal?

Instead of trying to predict where stocks are headed, how about we focus on the volatility markets.

The Current Readings

Equity volatility is being pumped up as the Fed outcome is being treated as an earnings-like outcome for the markets.

At the time of this writing, VXST (short term volatility) is at 28% and the VIX is at 24%.

Contrast that with the actual volatility in the market which is sitting at 15%.

That's a pretty hefty premium.

My End of Year Volatility Predictions

Volatility will spike but only for a day or so. After that, the actual volatility in the market will head back to 10% or so.

Remember, after the fed meeting we've got a week then Christmas. Overall trade and liquidity will wind down as trade books close and fund managers wrap up their

As the main risk event investors are concerned about is the Fed, the need for post-Fed protection will be less. The holiday trading season will get priced in and we'll see the VIX head lower. January SPX options and VIX futures will also see their premium levels drop.

If anyone buys protection it's going to be out in February. That will coincide with the start of earnings season for stocks. On top of that, the next Fed meeting will be at the end of January, which is after options expiration.

Looking at the VIX futures curve, here's what I expect:

vix-futures

Technically, December VIX futures expire before the Fed meeting but the overall idea here is that:

  1. Near term vol goes down
  2. Jan vol goes down
  3. Feb vol probably heads lower but stays bid relative to jan
  4. VIX futures curve will head back into contango

What If I'm Wrong

My opinion is that the current premiums being traded in stock options is very rich and will not be justified.

And remember...

the only way for it to be justified is if we actually see a larger volatility move than what the market is pricing in.

As an example, the SPX Dec options chain is pricing in about 50 handles worth of movement.

spx-pricing

If you think we can move bigger, then you should be buying the straddles right now.

It's possible that this trade thesis doesn't pan out.

I believe that the only way I'm wrong is if we see a non-fed catalyst come out.

It would have to do something with the high yield debt risk spilling over, or potentially a large oil firm that surprises with ugly guidance.

Maybe something out of a BRIC nation. But none of those catalysts are really expected until the beginning of the new year.

How to Position Into It

I've already structured trades into this trade thesis, let's have a look at a few:

Sell Put Spreads In Relative Strength Names. It's easier to hunt for a bottom in stocks like FB and AMZN than it is in the S&P 500. Good stock selection has worked great in 2015 and I expect it to continue into the end of the year.

Shorting VXX. I'm not going crazy short here, but I do have some smart limited risk plays that profit if VXX starts to trade lower.

Income Trades in Jan and Feb. Take advantage of the high option premiums and the holiday trading season by deploying iron condors, butterflies, and calendars. Don't overstay your welcome and look to scale in if we do end up seeing a big move.

 

Why is the Market So Wide On Options?

Some days, it feels like you're just getting screwed.

You get bullish on a stock, so you put an order in to buy a call. The bid/ask spread is .50 wide, which means if you use a market order you're already down $25 against the mid.

Instead, you opt for bidding at the mid... but no fills. Instead, a rush of orders come in exactly at the price you wanted. And they end up getting filled before you!

While you're sitting there for a fill, the stock ends up taking off without you. And a missed opportunity can feel just as bad as a losing trade.

The Stock Is Wide So The Options Are Wide

Many times, the option market is very wide because the stock market is very wide.

Take an example like AMZN. At the time of this writing it's trading in the 500s which is pretty high relative to most of the market. Keep in mind, this doesn't include considerations like market cap, just that a single share will cost you $500.

Here's a look at the order book of AMZN:

amzn-depth-of-book

This was taken at the open and the market was pretty thin to begin with... but let's use these quotes as a jumping off point.

Say you went out and bought an at the money call at market, which guarantees a fill at whatever the asking price is. Because the call is ATM, it's going to have a delta of 50. This leaves the market maker net short 50 shares.

In order to balance that exposure out, the market maker can either use other positions on their book, or they can go buy 50 shares of stock on the open market.

The market's bid/ask is 544.35 x 544.87. That means the spread is 0.52 wide. And that's only on 2 lots to the bid and 1 lot on the ask. If you had to buy 500 shares at what the market is currently showing, that last round is 544.02 on the bid and 545.88 on the ask-- a spread of 1.86.

This calculation assumes that there's no hidden liquidity (which there is) or that more bids won't step up (which they will).

Go back to the market maker with a net exposure of -50. If they were to immediately get flat using a market order, they're already at a $26 disadvantage in the market just due to slippage.

In order to adjust for that slippage, the market maker will only put quotes out at levels that compensate for the slippage in the stock market.

You'll see this more on large priced stocks like AAPL CMG AMZN and NFLX. And it becomes even more pronounced on stocks that don't trade much volume to begin with.

If you're seeing a not-so-liquid options market, it's probably because the stock liquidity isn't that great either.

Markets are More Inbred

With more and more algorithmic trading, you end up with the robots trading against each other in the same markets.

On the stock side, two great examples are SIRI and AMD. They are both large companies, but the stocks trade under $5. And they trade 10s of millions of shares per day.

I have a suspicion that the overall order flow is not due to large institutions getting in and out of the stock, but algorithmic trades using a combination of market microstructure and exchange rebates to milk the market.

We then end up with stocks that generate liquidity inbreeding.

Same thing happens in the options market.

The popularity of certain stocks and etf's mean that 80% of the liquidity is in 20% of the market.

It ebbs and flows, of course. I remember back in 2007 during the big commodities boom ag stocks like POT, MOS, and MON were all the rage and had super liquid markets.

Right now it seems that most of the liquidity for options are in high beta tech stocks.

The liquidity inbreeding becomes even more pronounced when we look at options duration.

Everyone and their mother now trades weekly options. Some people like them for the amount of leverage you can get relative to total capital, others like how fast the theta comes in.

This ends up leaving longer duration options as a ghost town

What You Can Do About It

The first thing you should cut out is whining. If you think you're going to get screwed by the market, you get screwed. It becomes a self-fulfilling prophecy as it affects your psychology and how you approach risk.

Embrace the matra of "it is what it is."

If you don't want to follow the liquidity and trade weekly options, here are some tweaks to your trading to consider.

Trade Like a Market Maker

Instead of forcing trades, you can let the market come to you. Odds are if you're chasing a stock higher, it'll come back to your original price just given the natural volatility of the stock.

If you're trading option spreads, you should figure out the price given certain conditions and float orders out accordingly.

Change Your Execution Strategy

Novice option traders treat the market as an "all in, all out" kind of scenario. I think you can get a better edge through use of scaling in and out, taking advantage of the wide bid/ask spreads and the natural volatility of the market.

Believe it or not, there is liquidity in wide options especially if you are selling risk.

Think about it: if you are an institution with a ton of size in a stock and you want to hedge, you don't really want to use weekly options because they only give you 5 days' worth of hedging. There's demand in longer dated options if you are willing to step up and sell that risk.

Use Liquidity Pings

This is very useful on very wide markets like cash settled indexes (SPX, RUT, NDX).

When the bid/ask is really wide, the only way to find the true price of the market is to probe for it. If you put an order out and it's immediately filled, then try for a better price on your next round.

But if nobody is filling your order, you may want to consider walking the order until you find a fill. If the price isn't what you want then you'll want to consider avoiding the trade or using a different option strategy.

A Series of Unfortunate Risks

It's been a little over a month since the market crashed.

Quite a wild trip it's been.

I'd like to walk you through all the thoughts I had leading up to, during, and after that time to give you some insight into how I approach the markets and some of the absurdity you experience when trading.

Let's get started...

Markets Were Stupid Quiet

For the first 7 months of the year, the Dow Jones had been in the Tightest. Range. Ever.

In history.

For more context, here's a chart showing the Bollinger Band width of the SPX on a weekly chart.

bb-width

Bollinger Bands can show you the expected volatility relative to what we've seen in the past.

In simpler terms, it was the smallest non-reverting volatility-- in at least 20 years.

It had been a “golden age” for income trading. Iron condors were profitable and boring.

Boring is good.

Just like markets, volatility moves in cycles. So when you have vol low for too long, you should expect and anticipate volatility expansion.

So yeah I expected a shake and bake, maybe a "normal" correction... but not this.

Old Man Newsletters Demolished

Fear sells. If you’re scared, you are more likely to plunk down a couple hundred bucks to have some guy tell you exactly what you want to hear politically and give you advice about how to protect yourself against the fall of the West.

Their recommendations:

  • Gold
  • Gold Miners
  • Silver
  • Oil MLPs

I don’t need to put any charts up to show you how those have fared.

Breadth Sucks, Half Of Market Already In A Bear

Rightfully so, many bearishly inclined investors pointed out how the markets were riding on the backs of fewer and fewer stocks.

breadth

High beta tech and biotech were holding up the Nasdaq, and momentum on earnings was keeping the Dow elevated.

In the meantime, commodity stocks continued to be bludgeoned by the strong dollar and weak oil. By the time the crash came, oil stocks were already in a mature bear market.

And emerging markets were pretty ugly, which leads us into...

Dollar Denominated Debt Becomes a Risk

Similar to the 1997 Asian financial crisis, you had too much emerging debt that had to be paid back in dollars.

And if the dollar is strong, it becomes harder to sell things in a local currency and pay back the debt in dollars.

Here’s a chart of the dollar since 2014:

dxy

Basically, this theme was hanging on by a thread.

Speaking of Debt...

Oil has been in a bear market.

On the supply side, we've had a massive increase in oil shale tech that's come online.

On the demand side, China was weak.

During this "shale revolution" there was a ton of high yield debt issued for O&G companies. At current oil prices, many of these companies can't pay off the debt from selling the stuff they pull out of the ground.

Here's a chart of the performance of high yield debt compared to the 10 year yield:

hyg-ief

It's been ugly for a while.

And that's the thing! If you were short because of terrible breadth or credit market risks, you were months early. Timing still mattersn.

The Fed Got Faded

A key “warning signal” was back in Aug when there was a Fed meeting. The FOMC minutes came out and it was what the market wanted, but after a short lived rally the market continued to find sellers and selling led to more selling.

This in and of itself would have probably set off a “normal” correction, but then...

China Currency Explosion

China revalued their currency. Everything starts to smell of 1997, or potentially like 1998 when Russia devalued the ruble.

Way too many people are leaning the wrong way, and there’s no liquidity. We know how this played out.

Circuit Breakers Fail to Properly Flush The Market

Then the markets crashed.

A 10% pullback is pretty normal for stocks to have in a year. I think the average is something like -12%.

But to have it all in a 5 day period is pretty unprecedented.

So we come into Monday and futures are accelerating to the downside. Then they hit circuit breakers.

And in comes a liquidity issue.

Individual stocks and ETF’s see massive gaps lower. But even if you wanted to buy the dip, you really couldn’t.

The options market didn’t open for an hour after the open. Stocks were moving so fast that unless you had market buy orders on the open you didn’t get a chance to buy AAPL at 95 or FB at 75.

It was a crash that left the profits only to large institutions.

This is my surprised face.

The Analogs Come Into Play

As we have a tendency to do, humans search for patterns.

So everyone starts looking at past crashes to see if history will rhyme.

2011, 2008, 1998, 1997, 1987, and so on.

Ray Dalio event went as far back as 1937, talking about how Fed policy is similar to that.

Given how the market’s trading now, this feels more like 2011 or 1998. We’ll see how we trade into the end of the year.

Everyone Becomes An Expert in Everything

High volatility markets cause you to look at your assumptions. Is your investment or trading strategy sound? Are you taking on too much risk? What is your blind spot?

Thankfully, you have plenty of newly minted experts that are willing to open their mouth and sing songs about things they are totally unqualified to talk about.

I’d like to think I’m an expert in the VIX. I’ve analyzed it to death and actively trade vol instruments.

So when people start talking about an inverse head and shoulders in the VIX, I end up with a nervous tick.

And when people give opinions about the VXX without knowing how volatility futures come into play, I feel bad.

It wasn’t just in vol products.

Fund managers that normally scoff at technical analysis start using the word “oversold.”

Everyone became an expert in seasonality, sentiment, statistics, credit markets, Fed policy, ETF inflows, oil, the carry trade, options order flow… basically everything.

Because when markets are moving 1% a day there must be a reason for every single little tick.

Risk Parity Sucked - No Hedges Worked

A Well Balanced Portfolio.

Ideally you’d have some asset that protected you into the crash.

Well…

Treasuries sucked.

Gold sucked.

Basically the only thing that worked was long Yen or long vol.

And boy did long vol work.

Volatility Instruments Are Now Over Subscribed

There’s been a continuing shift out of vanilla hedging instruments like SPX puts, while more and more institutional players are using VIX products to protect against downside.

I’ve noticed it all year, where any decent pullback led to an over-sensitive move in the VIX.

The thing is, there’s only so many people that can get involved with vol products before liquidity runs out.

And that’s what happened.

Here’s a chart of VVIX -- it shows the demand for VIX options:

vvix

That’s the largest value ever. Even more than the 2008 crash.

Expect this trend of sensitivity to continue-- and realize that "smart money" really doesn't exist any more on the options market as a whole.

There’s Now Only One Bull Market

The only thing that seems to be working is One-Week Fantasy. Seriously, it’s been just a few weeks into football season and I’m exhausted seeing DraftKings ads.

Too Many Overhedged, Leads to Opex Rally

Often when you have a spike in the VIX like we did, you end up with way too many investors hedged and underexposed to the downside.

If people buy premium to reduce risk, then they don’t have fear of risk, which leads to a lack of downside fear.

Which means the market won’t trade to the downside hard again until all that premium burns off.

Here’s a chart of the SPX, with September options expiration highlighted.

spx-opex

Now that the market sold off aggressively and more people bought premium, I would not be surprised about a lack of fear until after Oct opex.

Everyone Looks for The Retest

There’s a psychological hack called “anchoring bias” that is often reflected in the market.

For example when a stock rallies to 97, odds are it will run to $100 because it’s a whole number and people anchor off it.

The collective psychology of the market starts looking for a retest of the lows.

When too many people focus on a level, one of two things happen:

  1. It doesn’t get hit
  2. We really overshoot

Right now we’re in scenario 1. If we get a short squeeze into Oct opex and then earnings suck, we could end up in scenario 2.

Carl Icahn Gets Drafted, Becomes Captain Obvious

Uncle Carl dropped fire onto the internet, with a 15 minute video explaining what everyone already knows.

Yes, high yield debt has been running hot

Yes, corporate buybacks are running hot -- except for AAPL, which is trading at a 9x multiple.

(Guess who’s long AAPL.)

This is all reminiscent of back in 2011 when Tony Robbins put out a “warning video” explaining how a trusted source (probably PTJ) talked about how things could get really, really ugly.

And yeah, it could be different this time. But all the risks outlayed in the video are pretty freaking obvious, now it comes down to whether there’s enough liquidity for those stuck in these positions to unwind their trades.

What Now?

Now it comes to brass tacks. Instead of talking about what has happened, what about the “hard right edge?”

First, time for a very poor joke.

A man walks into a bar, and sees an options trader.

The option trader nursing a beer, scrolling through his phone and pretending to ignore CNBC on the TV at the back of the bar.

The man asks the option trader “How are you doing in the markets?”

The option trader says “ask me at options expiration.

That was the joke. Sorry.

For my trades and the trade alerts at IWO Premium, we’ve done pretty good.

Into the crash, I was smoked on some income trades and put sales but the reversion into September options expiration turned these trades to small losses and profits.

In fact, all my put spread sales were profitable because of my stock selection and scaling techniques.

Simply put, if you’re going to trade options in this market, trade structure and position size matter much, much more compared to where your entry or stops are.

Seriously, What Now?

As for the market here’s what I think…

We’re probably going to rally into Oct opex. We got enough people that rebought hedges, and we’re seeing a momentum divergence already in the markets and some individual stocks.

  1. Iron condors on SPX and RUT can work here provided you size right.
  2. Buying Dec puts in VXX has a high odds of working.
  3. Trading the range by selling spreads against high beta names like AAPL, AMZN, FB, and GS has been working and will continue to work.
  4. Buying Dec calls in USO has a high odds of working.
  5. Buying Nov calls in oversold “fallen angels” in tech is a good trade. Stuff like FIT, PYPL, BABA, FSLR, and GPRO.
  6. If the markets retest recent lows again, they won’t hold and momentum will pick up again.
  7. SPX 2000 can come faster than you think. At the time of this writing we’re at 1930 so we’re 70 points away from that. We’d need to rally 3.6% to get to 2000… if you look at past vol and what the current risk premiums are, it’s very, very possible.
  8. The first run into 1980-2000 is an aggressive fade, but if SPX holds 1950 then don’t fade the next move and look for 2050.

If you want specific trade alerts and you want to join a community of amazing option traders, subscribe to IWO Premium.

I Was Long Into The Market Crash – Here’s What Happened Next

Last month, the market pulled back.

How's that for an understatement!

A 10% downside move is pretty normal for the stock market, but to have it happen in a week was crazy!

I'll be the first to admit I didn't see the crash coming.

Sure, there were signs of a pullback:

  • The Fed day was aggressively faded
  • Market breadth had been weak all year
  • Stock buybacks by companies were running really hot
  • High Yield debt has been flashing warning signs

I had been a little cautious... but I was still long stocks into the crash...

... but I still came out profitable on my swing trades.

How did I manage to do it? Keep reading to find the 3 things that saved my portfolio.

Limiting Risk

Instead of being long stock and panicking on the Monday Crash, I was using an option strategy called credit spreads.

pcr-example

These spreads limit risk in a trade, so even if the stocks I played went to zero I would only be out a specific amount of money. Limiting your risk using spreads can give you an extra psychological buffer if the market sees a strong move against you.

The other major advantage with credit spreads is that you don't need the market to be in your favor the whole time, because it is a high odds position that also makes money over time. Even if I got the direction wrong, as long as it wasn't a consistently downtrending market I would be OK.

Stock Selection

As I said earlier, market breadth had been very weak.

breadth

Smallcaps had been deteriorating, commodity stocks were already in mature bear markets... it was ugly even before the market crash.

The only thing really working was high beta tech and healthcare stocks.

Using a series of proprietary screeners and real-world experience, I made sure I was in stocks that bounced aggressively after the crash.

Executions

Finally, my main advantage into profiting during a market crash was in my execution strategy.

See, many option traders put on a trade and hope for the best into options expiration.

Trading using a "set and forget" method.

In my experience, that's the worst way to trade options, especially with credit spreads.

Jack Schwager, author of Market Wizards, recently said two important at an investment conference:

Position sizing is as important as entry price

and

How you implement the trade is as important as the idea you're trading

I believe that two traders can have the exact same opinion on a stock, yet one can be profitable while the other loses.

Adding position size and scaling techniques to your execution plan will give you a massive edge over others who are looking at the same trade setup as you.

In fact, with credit spreads you are able to enter and exit the same trade many times, increasing your profits without increasing your risk.

Sounds pretty good, right?

My execution strategy allowed me to be long AAPL, FB, DIS, AMGN and GS into the market crash and still end up profitable on all the trades.

How You Can Do It Too

This past month, I held a training with some clients about how to trade credit spreads using my unique style of scaling and executions.

Here's what we covered:

  • Defining and constructing credit spreads
  • Risk and reward in credit spreads
  • Major tradoffs with this option strategy
  • Psychological drawbacks and a solution to overcome them
  • A "tranche" framework for credit spread trading
  • How to trade credit spreads in a bear market

We also went into the 6 Trading Setups I Use:

  1. Rolling Returns
  2. PB2MA
  3. PB2BO
  4. Parabolics
  5. EPS 2nd Move
  6. 3rd Std Dev LL

You have the unique opportunity to access this training.

The market looks like it's going to be volatile for a while now... while many become fearful with this kind of price action, I view it as a profitable opportunity.

If you'd like to learn how to trade credit spreads the right way, you can access the training for a limited time.

The total investment in the course is a one time payment of $99.

Act Now, because once we gather enough client feedback, we will upgrade the course and double the price.

To lock in the current price and receive all course upgrades at no additional cost, simply click the button below, enter your payment information.

Once you do that, we will email you with your username and password to access the course.

CSC-BUTTON

As with all of my courses, this comes with a Risk-Free Guarantee. If, after 60 days, you find that it wasn't for you... just get in touch with me and I'll refund the full cost of the course.

With my setups the total investment of the course can be covered many times over on just a single trade. Don't miss out on this opportunity to add a new set of profitable trading setups to your arsenal.