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A Simple Volatility Trade for the Fed Voodoo

In the bustling little town of Jackson Hole, Wyoming, our favorite bearded economist Ben Bernanke will step up to the mic this afternoon to tell us what kind of tricks he has up his sleeves.

Nobody knows what he will say-- and more importantly nobody knows the reaction the markets will have.

But there is one high probability trade out there, and that's short volatility.

The Big Divergence

There is usually a relationship between implied volatility (future expectations) versus historical volatility (what's already happened)-- they will track one another fairly well, with the implied volatility usually trading at a premium.

But the bid in options in spite of a slow market has left these two measurements with a significant diversion (chart courtesy of LiveVol):

While the market has been in a super tight range, the expectation of large movement continues to permeate the markets-- everyone and their cousin is anticipating wild price action from the Fed's decisions on this fateful Friday.

And this bidup in vol could actually be justified-- we could be left with a 2% move in equities in a single day. But relative to near term vol, when we remove the event risk-- will the implied vol stay that eleveated?

Probably not.

How to Trade It

After the event, the VIX will probably get poleaxed and drag the rest of the vol complex down with it. The event risk will disappear, and the market will start pricing in a 3-day weekend's worth of time decay.

Spot VIX is currently trading in the high 17's, but the October VX futures are up in the 22's.

A simple, low-risk vol play here is:

This is a bet that the VIX will head lower and stay underneath 20 going into October expiration. It's almost a binary trade, so even though there is some complicated voodoo as to what underlying it tracks, it gives you very clear risk-reward in the trade.

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by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/