EQD Research: Volatility Trading Through The End Of The Post-Brexit Transition Period

The Brexit process continues with the next big deadline coming on December 31 when the post-Brexit transition period comes to an end. There is a lot of uncertainty as to what the end of this temporary normalcy will bring. The financial impact of moving to the next phase of Brexit will be felt most in Europe and no other index will reflect the market’s concerns or relief associated with this process than VSTOXX. Trading VSTOXX futures and options through the end of the post-Brexit transition period will offer up opportunities for those expecting elevated volatility to drop with a smooth transition or if the end of the transition period will bring more uncertainty and an increase in VSTOXX.

Smooth Transition

One interesting characteristic of the VSTOXX curve is how flat the shape is over the first seven months of 2021. Based on November 30 closing prices, the range of settlement prices for the seven active 2021 contracts is a historically narrow 0.50.

Data Source: Eurex

Many volatility watchers consider a flat curve indicative of market uncertainty. Typically, when uncertainty starts to come out of market, the VSTOXX curve shifts into what is considered a more normal contango shape. This involves prices moving higher based on the time to expiration. An outlook based on a smooth transition from the post-Brexit transition period would also expect the January VSTOXX® future to move lower, but also move lower by a greater extent than the February contract, especially with such a narrow spread. The basic trade based on this outlook consists of:

Sell Jan VSTOXX @ 22.20

Buy Feb VSTOXX @ 22.50

Some sort of target discount of January versus the February contract should be set as the exit price.  In early 2020 the January 2020 contract was trading at about a one-point discount to the February contract which may be a good baseline level to consider as a target price.

January VSTOXX options offer a variety of methods to trade a volatility drop that would follow a smooth post-Brexit transition. A benefit of using options is there is the ability to define risk, which in 2020 has been a necessity when approaching the markets. A common go to in this situation would be selling a call spread. For example, using November 30 pricing, one alternative is selling the VSTOXX Jan 20 Call at 3.75 and buying a VSTOXX Jan 25 Call for 2.35 taking in a credit of 1.40.

The maximum profit in this case is the credit of 1.40, while the maximum potential loss comes to 3.60. The risk reward on this trade is not terribly attractive. This is function of the skew for VSTOXX options where implied volatilities climb the farther call options are out of the money. An alternative, that improves the reward versus risk in this situation, would be an iron condor.

An iron condor is typically considered a neutral trade, but if the strike prices for the short put and call in the spread are positioned properly relative to the underlying market the trade can be applied to a bearish outlook. For example, with the November VSTOXX contract at 22.20, a trader could sell the VSTOXX Jan 20 Put for 1.55 and VSTOXX Jan 22 Call for 3.00. The spread could be completed by purchasing the VSTOXX Jan 15 Put for 0.10 and the VSTOXX Jan 25 Call for 2.35 netting a credit of 2.10.

There is more risk for this trade, based on a move to the 15 price level it has a maximum potential loss of 2.90. However, VSTOXX tends to move quickly to the upside, but with less velocity on downside. If the case of weakness in VSTOXX that starts to move toward the short put strike, there would be time to manage the trade, possibly locking in some sort of profit by covering the short 20 put.

Uncertain Transition

A second outlook involves an increase in volatility in early 2021 based on the end of the post-Brexit transition period. It is very likely that the discussions between London and Brussels will continue up to the final days of 2020 and uncertainty will dominate the European markets.  If the VSTOXX curve is still flat the opposite of the calendar spread above, buying January VSTOXX and selling the February contract is a viable trade.  A quick move higher in the spot VSTOXX index would have more of an upside impact on the January future than the February contract.

Long volatility strategies using VSTOXX options usually have a premium cost to them, but with the VSTOXX curve fairly flat and the futures in line with spot VSTOXX some basic option strategies might make sense. Using the current pricing of January VSTOXX options, the VSTOXX Jan 21 Call can be purchased for 3.50 and the VSTOXX Jan 26 Call sold for 2.05 resulting in a net cost of 1.45. The payout at expiration appears below.

In this case the break-even is a bit higher than where the futures were trading at the time the options were priced.  The maximum loss for this trade is the 1.45 cost of the spread with a maximum profit of 3.55 with a VSTOXX move over 26.00.

Another long volatility strategy that is commonly employed when there is a pending volatility event involves selling an out-of-the-money put and buying a call spread. For example, the VSTOXX Jan 20 Put could be sold for 1.50 and if combined with the call spread above would result is a spread trade that brings in a small credit of 0.05 and a payout at January expiration shown below.

This trade has the benefit of maintaining a small profit even if the bullish VSTOXX outlook does not play out as planned. The trade profit is maxed out at 5.05 if VSTOXX runs up to 26.00 or higher.  A drop below 20.00 results in losses accumulating on a one for one basis.

Finally, if there is any concern about a quick drop in VSTOXX or a need to cover the short put option the Jan 15 put could be purchased for 0.10 and combined with the previous trade. The result would be a combination of a VSTOXX Jan 15 / 20 bull put spread and Jan 21 / 26 bull call spread for a net cost of 0.05.

The payout on this final trade is similar to the previous trade.  Between 20.00 and 21.00 a small loss equal to the 0.05 cost of the trade.  Gains are capped at 4.95 if VSTOXX rises to 26.00 and the maximum loss is 5.05 with VSTOXX at 15.00 or lower.

All these trade ideas are priced using data a month before the end of the post-transition Brexit period, so market conditions may change as the end of 2020 approaches. We will continue to keep an eye on VSTOXX futures and options markets for trades focusing on the January VSTOXX contracts leading up to and after the end of the post-transition Brexit period.

Finally, starting Monday, December 7, trading hours will be expanded to cover the Asian trading day for VSTOXX Futures as well as Euro Stoxx Bank Futures, Stoxx Europe 600 Index Futures, and French Euro-OAT Futures. More details can be found in the Eurex circular linked here – 084/20.