Larry McMillan covers the nuances of using VIX calls when expecting a Bear market.
Historically the fall is known for sharp market selloffs. Typically when this happens, overall volatility increases. One measure of this is the VIX, a calculated value based on the implied volatility of SPX options. If you are bearish on the market, but bullish on market volatility, you may decide to buy a few VIX calls. In the following post, I will show that although this idea makes sense, not everything is as it appears.
Before we continue, it bears mentioning that the VIX options are different than most other index options. If you are interested in trading them, you would be well advised to read up on the subject. TradeKing's Community has a wealth of articles to choose from. Decoding the VIX, Decoding the VIX II, Back to the (VIX) futures, and VIX options and expiration are all written by Brian Overby. VIX Calls in a Class by Themselves and The Trickery of VIX Calls are by Doc Maher. If you are not experienced with call options, please visit Play#1 in the online version of The Options Playbook located in TradeKing's Education Center.
THE PLAY - LONG CALL
TRADE FORMATION
On July 23, 2008 at 9:31am, Community member Ameds entered the following:
Strike A: Bought to open 2 VIX October 22.50 calls at $2.70
Underlying at entry: October VX futures at 22.73
Other data: VIX cash index near 21.23
Current call market: Bid 3.10 - Ask 3.50
Maximum gain: theoretically unlimited
Maximum loss: debit paid of $2.70
ALL STAR COMMENTARY
This trader is looking for volatility to expand again, and he thinks it will happen prior to October. Therefore, he is buying calls on $VIX that expire in October.
There is a very good chance that the trader will be disappointed with this purchase. The reason I say that is that the $VIX is not the same as the volatility of October options (from the current viewpoint of July).
That is, the $VIX is a 30-day volatility. The actual definition can be perused here, if you so desire - although it's very technical and not at all necessary to understand the complete composition of the $VIX.
However, it is important to understand that it is a 30-day weighted volatility determined by using the two nearest series of $SPX options (those would be August and September options at this point). The implied volatility of November $SPX options controls the $VIX October options. The behavior of $SPX November options can be quite different that that of August and September options.
Furthermore, one must understand that the $VIX options are based on the VX futures (that trade at the CBOE Futures Exchange - CFE). They are not based on the $VIX itself, until the last moment of their life.
So, when the above calls were bought on July 23rd, we had the following situation:
$VIX: 21.31
Oct ‘08 VX futures: 22.73
Oct '08 VX 22.50 call: 2.70
One only needs to look at the $VIX options of last August, September, and October (2007) to see an example of how movements are much more accurately reflected in short-term $VIX options rather than longer-term ones.
Between August 8th and August 16th, 2007, the $SPX Index dropped a sharp, nasty 86 points, from 1497 to 1411. This is exactly what our trader hopes will happen again this year - at least sometime between now and October expiration. The following charts show the movements of the SPX and the VIX over the same one year period.
Click here for a larger SPX chart, or here for a larger VIX chart.
When that happened in August 2007, the $VIX rose from 21.45 to 30.83 on a closing basis, and actually traded at 37.50 during the day on August 16th.
Here's how the various $VIX futures performed during that time, using closing prices:
8/8/07 8/16/07 % Gain
$VIX 21.45 30.83 +44%
Aug '07 VX futures 22.07 30.60 +39%
Sept '07 VX futures 21.83 27.25 +25%
Oct '07 VX futures 21.29 23.50 +11%
Calls on the various months would have mirrored the performance in their respective futures contract. Hence a $VIX October call would have increased only a tiny bit in value, since the underlying October futures only rose slightly more than 2 points; whereas an August $VIX call would have soared, since their underlying instrument rose 8-1/2 points.
The above table lists closing prices. If intraday moves were considered, it would have been even more dramatic. The intraday high on the Oct '07 futures was 24.73, while the intraday high on the Aug '07 futures was 37.03!
In other words, the movements in the $VIX were much more accurately reflected in the August futures than in any of the longer-term futures contracts.
The moral of the story is that if you want to speculate in $VIX, buy short-term $VIX options and keep rolling them out if you have to.
If you buy longer-term options and the $VIX makes a strong move in the short term, you will most likely be disappointed, for the longer-term futures' movement will be dampened.
President
Larry's previous posts: Comparing Historical and Implied Volatility and MSFT Finish Low FROs are High on Profit.
For a list of previous All-Star Trades, please click here.
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This comment and any market data included here were prepared on July 29, 2008.
Nicole Wachs contributed to this blog.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Lawrence G. McMillan has a professional business relationship with TradeKing.
