The next two days I will be moving things around to prepare for the next cycle. (This week’s newsletter will be out tomorrow at around 10pm.) If the market wants to march higher in a straight line tomorrow, that will make things easier and offer the best prices.

Meanwhile, the NYMO is showing short-term overbought levels:

The NYMO is the black line plotted against the SPY. The high for the NYMO in 2014 was 68 in February (just before Feb’s VIX expiration, shocking), and while it does not portend of a drop in the S&P 500, it does usually mean that some sideways action is in order at a minimum.

If the market does turn lower after Wednesday, it will be interesting what the media invents for a reason this time….

This average daily return is .55%, as compared to .03% for all days since 1950. I will have more data going back a few more years soon.

Meanwhile, the September VIX future, which is 90% of the short-term VIX ETNs now, is nearing support:

I’m eyeing Monday and Tuesday as the time to start some long vol positions.

VIX January Futures: $17.10

VIX January (VIN): 17.36

The VIX is actually in slight backwardation, as the next month (VIF) is sitting at 17.25. Yet the VIX futures are trading at $17.90, comfortably in contango. Therein lies a nice set-up for a synthetic VIX short trade, using VIX futures in the VXX exchange traded note.

A nice trade exists in the January VXX $28 puts, for around $1.20. The VIX futures falling to  16 would do the trick, when along with the contango daily headwinds and positive seasonal bias in the equity markets could easily bring the VXX to below $28. That would generate a return of nearly 100% in the VXX $28 Jan put. The VXX on Wednesday held 100% January VIX futures.

The major risk to this strategy is clearly the path of fiscal cliff negotiations. Yet, a resolution of some sort will occur before the expiration of this contract. And what if the deal is made before January? That is how strong the move to the downside in VIX could be in the next two weeks.

Normally, considering where we are in the OPEX cycle, we would potentially opt for VXX weeklies, using our proprietary Volatility Wave model. (This is a VIX forecasting tool that allows us to predict implied volatility movements. Contact us for more information.) Yet the fiscal cliff wrangling is causing us to push out the trade, yet we can still maintain exposure should a deal come early.

We will post the trade and prices this morning when the position is established.

Trade Update: Long Jan VXX $28 put at $1.18. 9:56 am.

Trade Update: added at .92, 3:38 pm.

Trade Update: added significantly at .53 on 12/21 3:40pm.

Today the algos hit the tape on Senator Reid’s comments, just a daily example of the headline-programmed high frequency traders moving the market. And with hedge funds getting badly beaten by the S&P, this is creating a very difficult situation, in a time period when the market performs quite well historically. December is the #1 S&P 500 month since 1950 for performance and #2 on the Dow and Nasdaq. So what do you do, invest client funds just to watch them crater whenever the circus in Washington decides to put personal objectives ahead of the U.S. economy? Just in time for those statements to get printed.

Hedge Funds Badly Beaten by S&P 500 Performance
Just 13% of hedge funds are beating the broad market indicator
http://www.advisorone.com/2012/11/26/hedge-funds-badly-beaten-by-sp-500-performance

The VIX has taken this pending situation with nary a quiver yet, but this may be due to the seasonal tendencies of the VIX. (see our recent posts for more on VIX seasonality) While exchange traded funds holding VIX futures have multiple headwinds, the differential between the near-term VIX futures contract and the VIX is not one of them:

The spread between the December VIX futures and the VIX is only 1.4%, and the VXX short-term futures ETN has just rolled to hold all Decembers a few days ago. Therefore, a spike in the VIX will translate to a highly correlated spike in the VXX. This is fairly rare, since there are usually multiple buffers to prevent this type of action. Only for a short time period will the fund hold a vast majority of near month futures, and rarely with this much time until expiration will the VIX/VIX futures spread be this tight.

The bottom line is that the VXX is not as bad a hedge against volatility as it usually is. Let’s examine a long volatility trade:

December VIX option at the $15 strike – $1.80 (VIX current price $15.72)

December VXX option at the $30 strike- $2.00  (VXX current price $30.36)

The VIX options represent expectations of the forward value of the VIX; that is essentially what the VIX futures represent. For 12% you get an at the money hedge against the VIX. For 6.6%, you get almost the same hedge. The negative roll yield is -.5% per day, so that should be factored into the trade. Yet, you will get a better response on short-term spikes with the VXX. Today exemplified this mispricing as the VIX $15 strike option traded 16% higher and the VXX $30 strike option moved 26%. The VIX index rose only 2.7%. This result makes perfect sense considering the price inequity.

Believe it or not, this is usually the reverse of the typical VIX/VXX arbitrage trade setup where you get long VIX options and watch the short VXX options decay due to the normal yield and spread scenario.

Follow us on Twitter and Stocktwits @VolatilityWiz, and visit our website for trading ideas at VolatilityAnalytics.com. We have proprietary strategies for both institutional and retail investors.

VIX Term Structure:

Data courtesy of the CBOE.