Daily Options Report

So I mentioned the other day I'm buying April puts in SPY vs. shorting April VIX calls.

My thinking is pretty simple. There's a rather large spread between the VIX itself and the April VIX futures. It's about 4-4.50 points. By definition, that spread will go to zero when the VIX setles in April. Unfortunately, there's no perfect arb spread to lock it in. So a better way to look at this is as two separate transactions that will have some correlation, but far from a perfect one.

April SPY puts near the money were around a 15 volatility. The April VIX future was about 21.5, and the April VIX calls have a volatility roughly 100 (though tough to find a system that correctly measures volatility of options on a volatility index). So that's a lot of room for error between the trades.

Now if held until or near expiration, a few things can basically happen. One is that the market just keeps on keeping on. If that's the case, the SPY puts will certainly go to wallpaper. But so will the VIX calls. Then your P&L depends on the ratio you did the spread. If you took in a net credit, you earn it, if you paid a net debit, you pay it. Very simple. To this point, I structured it to take in a net credit.

Number 2 is that we are in the same spot in April that we are now. The SPY puts will again close worthless, but the VIX calls are less certain, though remember that the current VIX future is way above here, so it's very unlikely a market that's flat over a month will see a big volatility spike. So again, you likely pocket the net credit.

But then there's Door Number 3: Market tank and volatility spike. You win on the SPY puts no doubt, but do you win enough? We've all seen VIX go exponential. So in my thinking, here's where the actual edge of the futures premium lies. The VIX already prices in a VIX lift from here, and using calls prices in a further lift off those levels. So much depends on the timing. If the VIX spike happens soon, then the calls will work both ways. On one hand, they'll still carry time premium in them. On the other hand, the April VIX, will not lift nearly as much as the VIX itself. Remember all the way in those dark days of January 2010? The VIX exploded 50% in a 3 day period, and VIX futures actually traded at a discount.

Of course that's only a spike into the mid 20's.What about a spike into, say the 30's? Well to me, that's the most serious risk here. It's highly likely your SPY puts have exploded too, but it's really impossible to know how much, to what extent the April VIX future tracks the VIX pop, et. al. given that we have not idea as to the timing.

So yada yada yada, I like this combo. Like anything I put out there though, it's a concept, I don't promise I won't change my mind in a day or a week. But right here, right now you have a market that's a bit extended and a VIX term structure that's a bit fearful.