It is entirely possible that the VIX and general market volatility remain subdued for the rest of the year. With so many managers underperforming the indexes, and lots of gold and bond money floating around, there could be a constant bid for stocks heading into year end. This is before any POMO consideration, which I think is over-rated in effectiveness, but has powerful psychological market implications.

I’m not predicting market direction, just surmising that there could be a line of folks looking for an entry, so pullbacks could be small. Thus, the VIX will not respect a falling market until it demonstrates an ability to violate widely watched levels, like the infamous 50 day moving average.

What to do for vol traders? Quite simply, there are always vol opportunities when you consider earnings and event driven trades. Short-term options reflect the potential for big moves, while the longer-term options reflect less volatility. Interestingly, for true vol fans, this concept is discussed by Jamie Mai in Hedge Fund Wizards, one of Jack Schwager’s great interview-style books. Jamie discusses why it is counter-intuitive that longer vol should be lower than short-term vol when the potential for major unknown event risk sits between the short options and the long options. Check it out for some fascinating reading.

A terrific platform for vol trading is LiveVol, and I have had the privilege of giving it a test drive over the last couple weeks. Vol traders will absolutely love this, it is built specifically for them. And earnings season is perfect for a platform build for setting up vol specific trades.

Let’s look at a specific example using NFLX:

The weekly implied volatility (circled) is 80 points higher than the January calls. This is an excellent opportunity to sell one against the other. When earnings are revealed, the short term IV will implode, while the long-term will fall at a much lower rate.

This is the trade I put on this morning:

Short NFLX weekly $380 for $7.26

Long NFLX Jan 2014 $380 for $17.81

Net debit $10.55

This was set around 10% out of the money when I put it on, and NFLX rose by 5% during the day and 9% after hours. I specifically set the short call 10% out of the money, as I felt I was getting a good value provided by short-term earnings traders. This trade had only about 50% of overnight downside, but has unlimited return potential.

AMZN, FB, and countless other weekly options provide this opportunity. So while the VIX is low, selling vol is still easy to do on an asymmetric risk/reward basis.

The headlines will say that the market sold off today, but in reality the futures brought down the opening marks which were then bid up most of the day. Tech stocks briefly went green and small caps (IWM) closed in positive territory. The consensus opinion is that the market will rocket higher as soon as D.C. makes a deal, and I must have heard the phrase “buy the dip” 100 times today. There aren’t many bears out there. I was also amazed at how many people were talking about selling volatility, as if there will never be a VIX over 17 again, and these pundits claimed it was a terrific opportunity to sell vol as there is no real market risk.

Someday these folks will learn the hard way that being blindly short volatility can have painful consequences, but it is anybody’s guess when that will be. A lot of today’s vol sellers haven’t seen the VIX really rip higher, it has become sort of a free lunch for them. The VIX futures did not respond commensurately to the rise of implied vol in the S&P puts, as October only rose 4.5%.

Obviously, VIX futures holders expect vol to fall quickly, regardless of the debt ceiling battle immediately behind this one. Even more consensus opinions claim that it is good that D.C. is battling now, because the losing party will not put up much of a fight in the debt ceiling deal.

Clearly, nobody expects anything bad to happen, in the media anyway. I am a bit more cautious and can wait to sell vol when either these things get cleared up or the price for vol goes high enough to compensate for risk. The momentum stocks, small caps and tech stocks have not corrected in the slightest bit, and that means that vol is too low for me to sell it now. Sure we could rip higher if some deal occurs, but you can sell vol for days after a vol exhale, you don’t necessarily have to put yourself out there being early.

It will be interesting to see if now that the quarter is over, some of these outperforming sectors will sell off a little, after they’ve been propped or painted into quarter end. Recall that October is #11 out of 12 for the Russell 2000 and vol has a history of rising into this month, we are now at day 25 on this chart:

 

Today was a great day, as I came in short Russell 2k and Nasdaq futures and covered them up early in the day. i was also short crude and covered that also. At the end of the day, when the almost traditional end of day spike arrived, I reshorted both, but this time my stops are quite tight due to the potential for some kind of resolution in D.C.

Seems to me that people are way too bullish and complacent right now. I will get long if the market tells me too, but I am currently more cautious than the crowd. There may be a much better opportunity to sell VXX and VIX call spreads in the weeks ahead, or maybe just get short VXX or UVXY. I will wait a bit and see what happens.

What was different about today that changed the volatility landscape? The S&P fell 7 points, but it has done that for 5 out of 6 days on low volume with the VIX turning a blind eye to all prior dips. The Nasdaq and Russell 2000 barely fell, and are right near their highs. It appears that the beta race by underperforming managers is on, and they will use the momentum names and small caps to desperately catch up.

Could this mean a big push into the end of the year? Quite possibly. But the street seems to know the future already, with everybody claiming the market will be bought at the infamous 50 day moving average. So they can see everything so clearly, a mild pullback as they wait for DC to inevitably compromise, then higher. When everybody is thinking the same thing, it makes me consider the alternatives, like the possibility of something unexpected.

The futures rose, and with over two weeks to expiration met spot VIX. In fact, the spot VIX was higher than the October future for part of the day. This is unusual, as the time premium usually has the future trading higher than spot VIX. Furthermore, the weekend sees spot VIX fall anticipating weekend decay in the options. So, while the VIX level is not high buy any means, it is starting to respect the potential for shenanigans in DC.

This was one of those days where new and uninformed VXX traders sit confused wondering why the VXX was not up 10%. At this point, the VXX is holding about 40% of the more expensive November future, and this will impede a move higher. The futures are not convinced of any real blow up in DC, but why should they be? Real volatility is a distant memory and a lot of folks have made bundles shorting vol. One of these days, this will burn a ton of people.

I closed the remaining Oct VIX $14 calls I had for 1.70, which was a nice return from $1.35 and $1.40. It obviously is too early to sell volatility here. I would be much more inclined to begin selling vol over 17.

If you think we’ve corrected somewhat in stocks, take a look at this chart:

Or this one:

The indexes are basically at the highs. October is a challenging month historically, #8 for the nasdaq, #11 for the Russell 2000, and #7 for the S&P. In fact, the smart money is looking for this to change. The IWM, a proxy for the Russell 2000, saw 4x as many puts as calls trade today. This is an amazing ratio:

I have been short Russell 2000 futures for a couple days and I added a small short Nasdaq futures position as well. I will not fight these, and I will get stopped out on any move higher, period.

As the markets continue to act poorly for the fourth day in a row, participants are far from concerned as the VIX and futures fell. When the Russell 2000 rolled over in the last hour of the day, the VIX and VIX futures barely noticed:

If you look at the implied volatility in the SPY for example, you will see incredibly low numbers considering the fact that we have a DC debacle brewing, poor market behavior, and seasonal weakness as potential market headwinds. Check out the implied vols for this week and the quarterly options:

This is confusing, I must admit. I closed some October VIX $14 calls for a small profit at $1.55, ($1.35 and $1.40 entry) as I am not going to accept a vol exhale should something positive occur in DC over the weekend. I would much rather sell volatility instead of waiting for it to arrive, and I have seen enough to consider that it is possible it may not show up. No sense hoping, there will always be other opportunities, and selling vol is easier anyway.

The MACD is about to give a sell signal on the S&P, yet the NYMO has retreated to neutral levels. The Russell made an all-time intraday high today, and that signals to me that there could be a lot of folks out there chasing beta due to under-performance. Regardless of the technicals, the market itself is still very vulnerable to a surprise. The abundance of put selling in the SPY is something to watch. If the market falls, the delta hedge is selling the index, so it can sort of feed on itself.

 

True to form, Mr. Bernanke did it again. With zero change in policy, markets rallied and volatility evaporated, consistent with the typical volatility exhale that occurs after he’s taken the stage before. The difference this time was that markets were near the highs and volatility was already low, so the futures could only fall so far.

The VIX settled at 14.77 at the open today, which enabled us to profit from the 14/15 VIX calls spreads put on at .57. Not surprisingly, the 14.77 mark was the high of the day as out of the money puts were bid at the open, allowing almost the maximum pain for VIX put and call holders.

With a stalemate in DC and government shutdown looming, followed closely behind by the debt ceiling, it is not all roses for bulls going forward. It is probably a nice time to be adding/initiating vol positions for what will overtake the newswires in the weeks ahead.

The following chart should get your attention. The NYMO, or McClellan oscillator, a measure of under/overbought conditions in the markets, is the highest since July 2011. That is precisely before the debt ceiling market crash of nearly 20%. I am in no way predicting anything like that, it is just a data point to pay attention to:

The VIX 13 and 14 calls are looking attractive. Believe me, I would prefer selling vol or shorting VXX in some way, but now is not the time. I sold the Dec S&P mini future contract at 1720.5, which is 50x the index. And I am long the VIX Oct 14 at 2.00, and I will add at around 1.30.

I can not recall a Fed meeting in recent times with so much complacency. The VIX has not risen in anticipation of potential volatility, and markets enter the uncertain announcement with bravado, near all-time highs. Sentiment is very bullish, where folks seem to expect positive results if the Fed tapers in the expected range, or if they don’t taper at all. In either scenario, higher prices are expected.

This market behavior should at the least get your attention to some potential downside. While it can certainly go higher, it can also surprise. Markets are challenged historically after mid-September until November, higher volatility may occur due to an impending budget and debt ceiling battle, and the S&P is extended and overbought signals are showing up in the NYMO and breadth indicators.

Typically, you would see an elevated level of volatility and a volatility exhale as the market receives the news. If that is the case, and it certainly doesn’t look like the markets are concerned in the least bit, then I suppose it is possible for October’s future could fall below 15. That is only a 3% drop to 15. With the VXX holding all Oct as of tomorrow, then the downside to the VXX is relatively limited. But it also means that if there is a surprise, the VXX can shoot up quickly, since is not holding more expensive November futures yet.

That leaves us with little to do in the vol space. Tomorrow will be all about the reaction and trading that. If vol falls significantly, I want to add to the VIX $14 calls, because there will be volatility in the near future. I am still also long the Sep spreads, which will break even if the opening VIX print tomorrow is around where it is now. The volatility I expected to even mildly enter the market never materialized, but as I sold the 15 and 16′s, the downside was minimal.

Here is the SPY chart. The MACD is bullish, the RSI is high, and frequently when you break the upper bollinger band, you can quickly revisit the lower band:

If we get a pop in the market, I will be looking to sell some spreads in the TNA, FAS, and SPY a week or two out. Next week has a notoriously poor history down 17 of the last 22 years. OPEX is Friday, and that is another wildcard, yet recently the the markets have performed well on expiration Friday. Remember this chart, we are about to enter day 20 on Monday, where historically volatility has risen: