Volume 15 Issue 10
VIX on the Rise Again [Chart]

As anticipated Friday’s nonfarm employment moved both fixed income and equity markets not because of fewer than expected job additions, but because of more than expected. The S&P 500 Index was already declining to retest the February 25 high at 2119.59 so the report seems to have increased anxiety about an early interest rate rise. It was like a skier on the down slope was pushed from behind by a sudden blast of cold arctic air and lost control.

After a brief market review, we report on the VIX hedge suggested in Digest Issue 9 “VIX Hedge Plan [Charts]” and offer another for long-term interest rates with ProShares UltraShort 20+ Year Treasury (TBT).

S&P 500 Index (SPX) 2071.26 after declining 29.78 points Friday, it not only blasted through support at 2100 but also declined below the December 29 high at 2093.55 and November support at 2075. Since the markets will anticipate any federal funds rate increase in advance, Friday’s market response could have been the first warning. Confirmation could come as soon at March 18, after the next Federal Open Market Committee meeting scheduled for March 17-18. The first likely step would be the removal of “patient” in the remarks referring to when the key interest rate will rise. The next support to watch is 2050. After that it would be 2025, the upward sloping trendline from the October 15 low that could contain the decline. Finally, the three-point intermediate term upward sloping trendline from the November 16, 2012 low of 1343.55 now crosses at 1925.20, 146.06 points or another 7% lower.

CBOE Volatility Index® (VIX) 15.20, up 1.16 Friday and likely to rise further until after the next Federal Open Market Committee meeting scheduled for March 17-18 as the bulls and bears battle it out.

The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan’s day-weighted average between the first and second months.

The day weighting applies 35% to March and 65% to April for a 13.36% premium shown above. Our alternative volume-weighted average between March and April, regularly found in the Options Data Analysis section on our homepage, is slightly lower at 10.92%. Premiums for a normal term structure are 10% to 20%, while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Alternatively, premiums less than 10% suggest caution and negative premiums indicate an oversold condition. Last week the premium began at 22.50% suggesting an overbought market and ended at 10.92%. If VIX continues increasing, as expected the premiums should decline below 10%.

VIX Options

With a current 30-day Historical Volatility of 112.35 and 94.58 using Parkinson’s range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday’s closing option mid prices along with their respective month’s futures prices, since the options are priced from the tradable futures.

Compared to the current range historical volatility of 94.58 both the March and April options appear inexpensive.

The updated CBOE Volatility Index® (VIX) chart shows it turning higher after approaching 12.50 early last week.

Since Friday’s decline was all about discounting an interest rate increase and the next data point will be Janet Yellen’s comments after the Federal Open Market Committee meeting Wednesday March 18 VIX could rise back up to the 20-22.50 area indicted in orange above.

VIX Trade Update

Last week Digest Issue 9 “VIX Hedge Plan [Charts]” included two hedging suggestions, one using March at-the-money options, the second with April options.

Using March 2, last Monday’s closing prices for the opening positions here is the mark-to-market results using ask prices for purchases and bid prices for sales.

March

The position was initially booked for a credit of .55 at the close Monday when the VIX was 13.04. Based upon Friday’s closing call bid price of 1.05 the gain would be .20 while the put ask price to close would cost .95 for a .45 gain. Total four-day gain .65

April

This position was booked for a .05 debit at the close Monday when the VIX was 13.04. Based upon Friday’s closing call bid price of 2.15 the gain would be .35 while the put purchase bid to close would cost 1.50 for another .25 gain. Total four-day gain .60

Presuming the most important driver for any continuing VIX advance is interest rate expectations and since the 17th is last day for trading March VIX options and since Janet Yellen’s comments will be on March 18, March options will be most sensitive to any further advance.

However, since March options also have the greatest time decay a long call in combination with a short put offers advantages.

In another less likely, but possible scenario, the markets could quickly regain their composure after Friday’s declines and volatility settles back down toward 12.50 expecting Janet Yellen’s comments will continue to include “patience.” If then disappointed the reaction could come Wednesday March 18. In this case, it would be better to use April options such as the next suggested position.

With a delta of one, the positive and negative Vega values not shown above, cancel out like Theta.

US Dollar Index (DX) 97.62 up 1.24 Friday The other important development last week was the breakout Wednesday above the previous high made on January 23 at 95.48 on news that the ECB would begin buying bonds Monday. Although now overbought and due for a pull back to retest the breakout the momentum is clearly to the upside renewing pressure on commodities including crude oil.

Hedging as suggested last week, although based upon expectations for a disappointing nonfarm payroll report proved to be a prescient call despite for the wrong reason. However, since equities were in the process of pulling back to retest previous highs the better than expected nonfarm payroll report uncovered the markets sensitivity to increasing interest rates as bonds and interest sensitive sectors like utilities took a drubbing. Presuming interest rates jitters continue at least until comments from the next Federal Open Market Committee meeting are released short long bonds and utilities should help to hedge other long equity positions. For example, here is a short suggestion for long dated Treasury bonds.

ProShares UltraShort 20+ Year Treasury (TBT) 46.16 + 2.00 or 4.43% Friday

Long bonds are already more interest rate sensitive than shorter-term instruments and ProShares UltraShort 20+ Year Treasury adds to the sensitivity making it an effective way to position for changing interest rates.

ProShares UltraShort 20+ Year Treasury seeks daily investment results, before fees and expenses, that correspond to two times the inverse (-2x) of the daily performance of the Barclays U.S. 20+ Year Treasury Bond Index for a single day, as measured from one NAV calculation to the next.

First from a trend perspective, here is the chart.

From the September 18 high, the current operative trendline, it now appears the trend has changed and is now higher. Notice the breakout above the Downward Sloping Trendline on February 13 and the subsequent retest down to 42.59 that held on February 25 as TBT turned higher and then confirmed by Friday’s gap breakout above 45.

Here is a suggestion to consider,

The current Historical Volatility is 34.63 and 22.82 using the Parkinson’s range method, with an Implied Volatility Index Mean of 28.40 down from 30.51 the previous week. The 52-week high was 37.30 on October 15, 2014 while the low was 18.53 on March 25, 2014. The bullish put call ratio was .25 while the implied volatility/historical volatility ratio using the range method is 1.25 so option prices are priced about right compared to the recent movement of the stock, but both should decline back toward 20 so there is some implied volatility risk. Friday’s option volume was 67,326 contracts traded compared to the 5-day average volume of 26,380.

While there is no implied volatility edge it does partially hedge both time decay and implied volatility. Using the ask price for the buy and middle for the sell, the debit is 1.34, about 33% of the distance between the strike prices. Use a close back below the well-defined support at the 45 breakout as the SU (stop/unwind).

The VIX suggestion above uses the closing ask price for the buy and bid prices for the sell. The TBT suggestion uses the closing ask prices for the buy and middle price for the sell presuming some price improvement from indicted prices is possible. Monday’s option prices will be somewhat different due to the time decay over the weekend and any stock price change.

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Summary

Just when it appeared equity prices would resume trending higher, the game changed Friday as both the bond and equity markets reacted extremely negatively to the better than expected nonfarm payroll report. Now the focus is likely to shift to comments after Federal Open Market Committee meeting March 18 to confirm or deny the date for an upcoming change in interest rate policy. In the meanwhile, since the markets revealed their interest rate sensitivity on Friday additional hedging strategies could be prudent.