Arcángel de Jesús Montoya
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Arcángel de Jesús Montoya in Money Trafficking,

A Recent Hike In Volatility Uncovers An Interesting Non-Directional Opportunity In QQQ

In a recent video, trader Jonathan Rose stated that the VIX index (VXX) is going too low - to a point, where it cannot go any lower. Remember that volatility indexes are mean-reversible, meaning that they cannot grow or decline forever. VIX is no exception, and the recent data have proven this year again:

(Source: Google Finance)

Volatility indexes are strongly correlated with the underlying stock indexes they are based on. When volatility goes up, equity indexes go down - this is a simple rule. As always, historical data back this assumption:

(Source: Google Finance)

The above chart shows dynamics for S&P 500 and its volatility index, VIX, for the last three months.

As you can see from the chart, as volatility went down from the highs of January 2016, S&P 500 crawled higher. In fact, the equity index has shown a return of almost 12% since the beginning of the year, while the volatility index lost almost 50% of its value. What you should also see here is that the volatility index has bottomed: it has remained in the same bandwidth (-40% to -50%) for the entire month of April. Today, it went up by over 5%.

My historical data analysis (using daily prices data for the last year) shows that a one-standard deviation change in daily prices for VIX is about 4.9% (that is, a "normal" absolute change in price that has a 68% chance of occurring, if the distribution of the price changes is normal). However, the price changes' distribution is not really normal because, as empirical evidence shows, there is only a ~27% chance of seeing a change greater than 4.9%. In fact, there is only a 13% of seeing the VIX going higher than 4.9% in a whole year. We can therefore infer that that the change in VIX today was out-of-ordinary. The change in the value of the index has found itself between one standard deviation (4.9%) and two standard deviations (9.7%). This is significant and may mean that the volatility can be on an uptrend pretty soon. The upcoming Fed meeting is definitely not going to reduce volatility on the markets.

VIX is not the only index that is strongly correlated with S&P 500. We know from experience that equity indexes in general are correlated with each other, especially during the time of market turmoil. PowerShares Nasdaq-100 (QQQ) is a very popular instrument (in fact, it is an ETF) designed to track changes in the NASDAQ 100 index. It has a fairly strong correlation with S&P 500, as evident from the illustration below:

(Source: Google Finance)

The above chart shows dynamics for S&P 500 and QQQ for the last 52 weeks.

A quick statistical analysis confirms the visual evidence:

(Source: Google Finance data. Calculations by author)

The R^2 reading of 0.694 may not seem very strong, however, the R reading of 0.833 suggest that the correlation between daily price changes between the two indexes is very solid.

In addition, my analysis shows that the two indexes very strongly correlate during two-standard-deviation events in over 50% of time:

(Source: Google Finance data. Calculations by author)

There have been 13 events in the past 52 weeks when both the VXX and QQQ indexes moved by two standard deviations a day simultaneously.

As opposed to VIX, QQQ has historically shown relatively low volatility in daily prices:

(Source: Google Finance data. Calculations by author)

The above calculations use daily price changes' data for the last 52 weeks.

As you can also see in the above chart, QQQ's volatility has gone down significantly in the past thirteen weeks (one quarter): the annualized volatility is at the 52-week low (13.35%) and has demonstrated the largest decline in the 52-week period analyzed. This low volatility, coupled with the upcoming Fed meeting and the mean-reversible nature of VIX, presents in interesting non-directional opportunity in QQQ's options:

(Source: TD Waterhouse)

(Source: TD Waterhouse)

Essentially, my trade idea is to buy options in one of the expiration dates presented in the tables above. Because I only want to choose one trade, I have to pick the most attractive one. In this case, the most attractive trade is the one that is the most mispriced relative to its future volatility. Below is given the cost of the straddles using the ask prices to ensure conservatism in calculations:

(Source: Google Finance data. Calculations by author)

The relative cost is calculated by dividing the price of the straddle by the current market value of the underlying (approximately $110 per unit).

For convenience purposes, let us recall the historical standard deviation of daily returns table on the QQQ index: 

(Source: Google Finance data. Calculations by author)

Let us examine the two straddles. The one-week straddle (expiring on April 29, 2016) is worth about 2.3% of the current market price of the underlying, which is more expensive than the calculated weekly volatility of the underlying based on the last four-week data (~1.9%). On the other hand, it is undervalued relative to the three-month and the six-month averages (2.75% and 2.85%, respectively).

On contrary, the one-month straddle (expiring on May 27, 2016), which costs only 3.55% of the current market price of one QQQ's unit, is undervalued to any historical data point on the chart above. In fact, even its cost increases by 30 basis points to match the lowest monthly volatility on the chart (calculated to be 3.85%), the straddle will gain at least 8%, fees and taxes excluded. If the volatility climbs up to the 13-week or the 26-week average monthly standard deviation, the value of the straddle will increase by at least 58%! My choice is obvious - the May straddle.

Let us summarize the key points in this trade idea:

(1) Equity indexes are correlated with their volatility indexes and each other;

(2) Volatility indexes are mean-reversible. VIX, the key volatility index on the market, has bottomed and showed a massive gain today. The probability of such event is quite low, as historical data show;

(3) The options on the equity index of my choice, QQQ, have not reflected this change in volatility yet;

(4) Historical data on the daily returns in the equity index show that volatility has been declining for the past six months. Hence, the straddles are very cheap relative to historical volatility data;

(5) I intend to buy the May straddle because it shows the most mispricing from the two straddles of my choice. Hence, it offers the highest potential return, if the volatility returns to its mean levels;

(6) I believe that the upcoming Fed meeting will be another source of an increase in volatility (the first one is the mean-reversible nature of the volatility indexes).

I provide a risk-return illustration for the May straddles:

(Source: optionsprofitcalculator.com)

The above chart shows values for the straddle at different market levels of the underlying given various dates. The maximum loss is $391 per contract (one options contract is one hundred shares), while the maximum gain is theoretically unlimited. The break-even levels in the underlying are $113.80 and $105.70 at expiration (March 27, 2016).

Based on the assumptions outlined above and the favorable risk-reward ratio, I find the trade to be very attractive. 

Keep in mind that options are volatile instruments. With this particular trade, there is a possibility of a significant loss in the principal.