Market volatility has reached its lowest point in the past six months, as indicated by the CBOE Volatility Index (VIX), a key measure of market expectations regarding short-term volatility in the S&P 500 index. Yesterday, the VIX closed at 14.75, signaling a period of relative calm in the markets.
The VIX is widely used by investors and traders as a gauge of market risk, fear, or stress. With low volatility in sight, there is interest in strategies that could capitalize on potential future increases in volatility. One such strategy is the long call butterfly spread using VIX options, which traders are considering for the upcoming year.
A long call butterfly is structured by purchasing a call option, selling two higher call options, and then buying another call option at an even higher strike price. This trade is entered for a net debit, meaning the trader pays to set it up, which also represents the maximum potential loss. Typically, a butterfly spread is positioned near the at-the-money level, but, in this case, the focus is on an out-of-the-money setup.
For the February 18th expiration, this trade would involve buying the 15 strike call, selling two of the 20 strike calls, and purchasing one of the 35 strike calls. The cost of entering this trade would be $250, establishing this amount as the maximum possible loss. The trade presents a potential maximum gain of $750 if the VIX closes at 25 at expiration, with breakeven points set at 17.40 and 32.60.
There are three potential scenarios for this butterfly spread. If the VIX remains below 15, the trade results in a loss of $250, which could be manageable for many investors, especially if stock prices continue to hold steady or grow. If the VIX fluctuates between 20 and 30, the trade may benefit while simultaneously presenting challenges for stock portfolios. Conversely, a VIX rise above 30 could lead to losses on the butterfly trade in addition to significant drops in stock portfolios.
The potential scenario of the VIX surpassing 30 highlights the inherent risks associated with this trading strategy. Nevertheless, VIX options offer a cost-effective means for investors to shield themselves against sharp stock sell-offs that could occur between now and January. The entry cost is relatively low at $250 per contract, allowing traders to hedge their positions effectively.
It’s essential for traders using VIX options to comprehensively understand the differing behaviors of these products compared to standard stock options. As with any investment, thorough research and due diligence are critical before committing resources. This financial strategy could serve as an avenue for investors to safeguard their capital during unpredictable market periods.