Trading VIX vs. VSTOXX around US debt ceiling negotiations

Typically, expected volatility expressed by the Volatility Index (VIX) and VSTOXX (V2X) moves in sync as macroeconomic factors similarly impact the US and European economies. However, at times, there are more region-specific events in the US or European markets. It was a while ago, but leading up to the referendum, Brexit was a good example where VSTOXX was elevated versus VIX. The surprise outcome narrowed the spread as VIX moved up to close the gap with VSTOXX.

A more recent example happened in early June as the US avoided a crisis by increasing the debt ceiling. The US equity markets greeted this outcome and the VIX trended towards post covid lows. However, leading up to the decision, VIX stood at a premium relative to VSTOXX, but when it appeared a deal would avoid a catastrophe, the spread between the two quickly narrowed.

Of course, we cannot directly trade VIX or VSTOXX, but we can trade futures on these two markets. The most sensitive future to the spot index for both markets is the front month, which is currently June. As of mid-May, the June VIX Futures contract was at a premium relative to VSTOXX, ranging from about 1.00 point to as high as 1.35. Since the two futures markets have different trading hours, we use the 10:30 am New York time prices for a daily comparison. The chart below shows both markets from 15 May through 2 June.

The spread between June VIX and June VSTOXX Futures was consistently wide during the second half of May based on concerns the US may not resolve the debt ceiling crisis, leading to a government shutdown. However, during the final week of negotiations, the spread narrowed when an agreement appeared imminent. Eventually, the June VIX Futures was priced at a discount to the June VSTOXX contract. It´s all very interesting, but quoting a former boss of mine, “How does this help traders”?

First, if one of these markets is at a premium relative to the other due to a pending event, there may be a trading opportunity. Consider if we shorted the June VIX and bought the VSTOXX Futures. This relationship is basically 1 VIX Futures for every 10 VSTOXX Futures. We will see in a moment that this trade would have worked quite well as VIX dipped below VSTOXX. Consider if the US had created a global panic by not increasing the debt ceiling. According to pundits, the result would have been an economic disaster impacting global financial markets. If that had been the outcome, it´s a safe bet that VSTOXX would have rallied and possibly closed the gap with VIX. The VIX would have likely moved up as well, but since it was already a premium, it would be rising off a higher base. This means the long VSTOXX position may profit enough to more than offset losses on the short VIX position.

In addition to trading the spread, noting the price action over the final few days on the chart above indicates that traders were becoming less concerned about US stock volatility. That is a direct result of a growing belief in resolving the debt ceiling issue. Noting risk perceptions in the US are falling relative to Europe is a good indicator that the market believes lower volatility is on the horizon. That usually indicates higher stock prices.

On 15 May, a trader could short the June VIX Futures at 20.25 and purchase the June VSTOXX Futures for 19.40. If the trader exited the trade on 2 June, as the agreement appeared to be in place, the VIX short is covered at 16.80, and the long VSTOXX sold for 17.00. The net result is a gain of 3.45 from the short VIX position and a loss of 2.40 on the long VSTOXX position.

The future vs. future trade is very straightforward. However, with options available on both VIX and VSTOXX, there are many potential combinations to create long exposure to VSTOXX with short exposure to VIX. As with the futures, we priced VIX and VSTOXX options at 10:30 each trading day to explore potential option trades.

An initial strategy could be to short a VIX call and buy a VSTOXX call. VIX implied volatility was higher than VSTOXX, so this would offer a chance to sell an expensive option and offset the short risk by purchasing the VSTOXX call. Again, entering a trade on 15 May, the VIX Jun 21 Call is sold for 2.00, and the VSTOXX 23 Call is purchased for 1.25. Fast forward to 2 June, and the VIX Jun 21 Call could be repurchased at 0.50 while the VSTOXX 23 Call still has value and can be sold for 0.30. The net result is a gain of 1.50 on the short VIX call and a loss of 0.95 on the long VSTOXX 23 call.

The small gain related to this short VIX – long VSTOXX call combination is a solid outcome, but we felt the need to dig further and find a better alternative. One idea is purchasing a VIX put and combining this with a long VSTOXX call spread. We considered buying a VIX put and VSTOXX call, but when exploring numerous combinations, the cost made the trades unattractive. However, when looking at an option trade that is expensive relative to an outlook, finding options to sell can help lower the cost. One alternative involves purchasing a VIX Jun 22 Put for 3.30 and then buying a VSTOXX call spread. We chose to purchase the VSTOXX Jun 25 Call for 1.05 and sell the VSTOXX Jun 30 Call for 0.65, resulting in a cost of 0.50 for the VSTOXX portion of this trade.

This trade would have worked out well as the VIX Jun 22 Put could be sold for 5.30 on 2 June , netting a gain of 2.00. The VSTOXX side of the trade sells the VSTOXX Jun 25 Call for 0.20 and buys back the VSTOXX Jun 30 Call for 0.05 taking in a credit of 0.15. The net loss on the call spread is 0.35, resulting in a profit of 0.15 on that leg of the trade.

An attractive aspect of this trade is what happens if VSTOXX runs quickly to the 30s. A plan should be in place to monetize the VSTOXX portion of this trade. Recall that the VIX put was priced at 3.30. We can assume that VSTOXX in the 30s would offer the opportunity to exit the call spread with a profit of 3.30 which would cover the cost of the put. The payoff diagram below shows the payoff for the VSTOXX Jun 25 / 30 Call spread on 2 Jun based on various prices for the June VSTOXX Futures.

It appears that the June VSTOXX Futures at 33.40 on the exit date would result in a profit of 3.30 on the VSTOXX call spread. This offsets the VIX Jun 23 Put cost, resulting in a trade that comes close to breakeven depending on whether there is any value left in the VIX put. Even if the VIX put has no bid (can’t be sold), the result is a trade that breaks even.

In this article, we only looked at three ways (out of many) to combine VIX and VSTOXX derivatives into a single trade. The table below compares how these three methods fared between 15 May and 2 June:

The long VIX put combined with a VSTOXX bull call spread worked the best among these three choices. Note that this is not a blanket outcome, just how the trades turned out while the Debt Ceiling discussions dominated the markets. Remember, the VIX – VSTOXX relationship is very much in sync in most trading environments. However, when specific news may impact the US or Europe individually, we have seen the markets diverge. Those divergences may be profited from or used to make better decisions in related markets.