These are the times you should look forward to. People are starting to spend serious money on out of the money puts and pumping up the VIX. The low delta puts are catching a strong bid, and this is what gets the VIX surging. It has been a while since we’ve seen this, and it could go much higher. First, let’s look at the VIX weekly chart to get some perspective:

Realistically, we are not that high, in fact we are about average for an October VIX. Looking at past mini-crises in recent years, the VIX has been much higher. The last debt ceiling debacle saw a VIX of nearly 50. As recently as last December it was 23. So 19 is not that high, and this chart demonstrates that.

We have not had a real correction for over two years, so there are a lot of folks out there that have had nothing to fear for a long time. Add to that the consensus opinion that the government will come to a deal on Oct. 17th, and you have a recipe for a surprise. I’m not expecting a cataclysmic event either, but you must keep in mind what could go wrong.

This demonstrates how heavily bid the OTM puts were. Look at the low deltas as a percentage of put purchases on the SPY:

When the spot VIX and futures are in backwardation, the curve inverts and it is a cause to be wary. If you are short VIX futures for Oct, you should be sweating because the Oct future will get closer to spot as we approach the 15th, and that could be the height of concern:

Courtesy: Vixcentral.com

This structure means that the VXX and UVXY are adding value as they roll into November, by purchasing cheaper futures (NOV) and selling more expensive ones (OCT). This is positive roll and for the VXX and UVXY it is rare. But this situation can certainly imply more equity market pain.

I’m getting itchy to sell vol, but it is not the time, because we are nowhere near a resolution, and a lot of index charts are implying more downside. The S&P broke the 50 SMA today, and the Russell 2k just gave a MACD cross lower sell signal. I’m literally sitting on my hands right here, but should there be a break in the logjam (doubtful this week, IMO), then I will be ready to act.

Today had the feel of one of those days where shorts were stuck and there would be no way out. The SPY held the 100 day moving average to the decimal yesterday, and now it resides 21 points higher 25 hours later. Volume was quite low, the lowest since August 26th. Volatility fell, and is diverging from the futures, which means that the VXX was nearly flat as the VIX fell 4.4%. This is not rare, but it is interesting with the event risk that is present. Which will be correct, the futures or the options?

The futures are significantly higher than what the S&P options are indicating. Notice the huge difference between the VIX term structure (the actual VIX inputs using S&P option volatility) and the VIX futures:

What does this mean for the VXX? Quite simply, vol better show up, or the futures better hang tough heading into the Fed meeting. Otherwise, it is sitting on air without a net. The VXX is 50% of each Sep and Oct as of today. So it is buffered by a growing October holding that will have more resilience due to seasonality and the DC events coming after the Fed meeting. It is also rolling fairly cheaply. (relative to itself of course)

But as VIX expiration approaches on the 18th, the VIX and the Sep future will have to converge. In the VXX’s case, the longer it can roll into October by selling an inflated September, the better it will hold up. This situation is better played through the Sep future itself, and the call spreads I mentioned yesterday are nice way to catch the decay into expiration.

Another way to play this could be VIX option calendar spreads. This in effect is doing what the VXX has to do every day, buy the longer dated future and sell the near future. This would be like building in your own negative roll yield:

This is a terrific way to play the the event risk in multiple ways. For $1 you can sell either the $17 or $18 call in Sep and own October. If the VIX rises to 17 at expiration, that would essentially be a 2x or more return. If you let the Sep expire and hold October, you could take a bearish stance on the next debt debacle, or market seasonality being tough and let it ride. If volatility rises moderately, falls, or remains flat, this trade will work.

A lot of noise out there, but the markets have essentially gone nowhere since Kerry’s press conference on August 26th, subsequent sell-off and gap lower. Iron condor sellers are loving this environment, especially weeklies sellers. It is no wonder why folks have spent years fighting over the rights to make a market in the S&P options, they are incredibly lucrative:

http://online.wsj.com/article/SB10001424127887323514404578652211969315322.html

The market makers/sellers almost always win. It is not rare to see both sides of the SPY option chain showing red on the first trading day of the week, even if the index makes a .4-5% move. (Use diagonals for a fighting chance if you must trade these….see prior posts)

After higher futures prices coerced the market higher in an attempt to catch up to global markets due the the Labor Day closure, there was no conviction and the selling pushed it right back into the recent channel. I suppose you can consider gap filled. The S&P has done nothing since the Aug 27 open:

The SPY is riding the 100 day moving average, the slope of which is quickly flattening: If you’re wondering about the colored candles, this particular chart demonstrates the Elder impulse system: http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:elder_impulse_system

The VIX was more jumpy than the Sep VIX future; it opened lower, went positive, then almost reverted to the open price:

What looks interesting to me is a unique opportunity to be long volatility going into the Fed event, but also be short volatility for a post-Fed exhale after the Sep 18th press conference. Because the VIX futures expire the day of the event, you get a shot to be long vol without the event risk and also hold options that are short vol right after the event. I’m looking at two scenarios.

VIX Sep call spreads:

Since the FED meeting is the day the futures settle on Wednesday the 18th, you can buy a call spread and sell some premium in the outer leg, with the idea that the VIX will not fall before the meeting and you can collect the width of the spread.

The $15-17 spread will run about $.90 and if the VIX remains above 17 on Wednesday morning the 18th, you collect $2. Losses begin at $15.90 VIX at settlement. There are a bunch of combinations here, selling put spreads, widening the call spread, but the idea is the same. You are looking to use the event to expect an elevated risk level. I suppose that Hilsenrath can drop a tape bomb, but this is a delicate meeting and that seems doubtful. Furthermore, you have a host of other events brewing that should hold the VIX up.

Another way to achieve roughly the same thing but with potentially more upside potential is a VXX calendar put spread:

Sell the Sep 13th $16 put and buy the Sep 20th put for a net debit of around .27. If the VXX sits tight or drifts to $16 on Sep 13th, then you get a free runner for a volatility exhale after the Fed meeting. By then, the Syria situation could be clearer as well. If this trade works out perfectly, it could be a four bagger as the VXX heads to $15. You also can take it off next Friday if you so choose.

The VXX is holding nearly 50% of Sep and Oct as of tomorrow.

As the Syria situation is beginning to appear like bad parents having difficulty enforcing a one-week grounding for smashing the family car while drinking and dragging, the leaders will meet at the G20 in just days, as the big players return to the desks next week with little clarity. If this blows off, there’s the job report/Fed fiasco, DC buffoonery, and just plain bad market seasonality to deal with.

The VIX and VXX rose, catching up with the after-hours futures move we highlighted yesterday. The VXX also rose on a day when the market was up, which is pretty rare. It is not rare to see the VXX fall when the market falls, but the reverse is rare. This is indicating that the futures are seeing higher future vol than the options (significant premium over spot VIX) while one must keep in mind that the three day weekend decay will do some depressing in options vol, holding down the VIX a bit. The Sep VIX future:

The VXX is now holding 60%/40% of September/October VIX futures, so it is important now to give as much attention to the Oct future:

With October nearing 18, now things are seemingly reverting to the long term average for this time of year:

We may be nearing a point where shorting the ETN’s and selling puts against it will work nicely. This is a covered put. The idea would be to sell the VXX or UVXY, knowing they have long-term gravity, but in the meantime as the futures remain high, make money selling puts against the short position. This can be done for week after week in the VXX:

Meanwhile, oil decided to make me look good just hours after yesterday’s post:

Have a great weekend everyone. The next two weeks should be fun, if not sickeningly hyperbolic and repetitive. Maybe you can invite your friends over for a CNBC taper drinking game. (Fast Money is worth 50 “tapers” alone….)