Hedging and Trading Strategies Trading VIX Options Hedging and Trading Strategies Option Pit

What You Will Learn What Are VIX Options What Are The Characteristics How are they different that normal options What is the IV structure of VIX options What Causes VIX options to move Ways to play directionally using VIX options Ways to Hedge

VIX Options VIX options are NOT options on the cash VIX that is often quoted on TV VIX options are options on the forward value of the VIX This means they are an option on a volatility SWAP not on the VIX itself

Characteristics VIX options are European exercise This means that they cannot be exercised early Because of the European exercise, the underlying is a forward value of the VIX Essentially, the underlying is the VX futures, not cash VIX They have the same settlement procedure as the VIX futures

Volume Of Options VIX options are extremely liquid and trade very actively Trade is over hybrid and Open Outcry trading Markets are generally Relatively tight in the Near term typically .05-.1 wide (does not Trade in pennies)

Activity

Volatility The VIX of VIX options is the VVIX Index It often can seem very low relative to VIX, again this is because the option vol is more based on the movement in the VIX futures instead of the VIX options Futures realized volatility is almost always significantly lower than the cash VIX

VVIX VVIX will trade as low as the 60s in slow periods and can threaten 200 when the VIX is high and the market is in panic This week, as the SPX was tanking and VIX was rising, VVIX was not rallying, what does that say?

VVIX

Volatility Unlike the VIX relative to SPX, the VIX and VVIX are typically positively correlated When the VIX is rallying, the VVIX is typically going higher Especially when the VIX is moving from below its mean back toward its mean When the VIX is popping and VVIX is not, that can be a sign that smart paper is selling insurance rather than buying it

IV of VIX Options

Term Structure Unlike many equity products, typically near month implied volatility is higher than months further out This is partially because each month has its ‘own’ underlying and the cash is not the true underlying for the whole set of options

Underlying Price

Term Structure Each option trades vs the future that expires in the same month Because each option has its own underlying, many firms to not offer a margining discount on calendars and time spreads Because VIX options have different underlying it is entirely possible for a long calendar to trade for a credit This is unheard of in normal equity options

Term Structure Notice that may is trading at a large premium to June, but as the months move further out the Ievels begin to converge

Intra-month IV Structure Normally Indexes have what is called a backward skew, sometimes called an investment skew This skew is caused primarily by hedging activities and collaring

Backward Skew Notice that puts are more expensive than calls This is caused by collar traders buying downside protection and financing it using upside calls

VIX Skew Since the VIX is a volatility product, customers are more concerned about the product going UP more than they are worried about it going down (more similar to WTI than SPX) Thus, the VIX has forward skew where calls are more expensive than puts This contributes to VVIX positive correlation

VIX forward skew Notice that upside calls trade at much higher IV’s than near the money and bearish options Traders usually do not use a collar in VIX options, they typically simply buy calls

Underlying Price

Using Options Recall that VIX options ATM strike is NOT the cash VIX level but the Futures ATM for Oct is 16.4 ATM for Nov is 16.70 ATM for December is 16.89

Estimating the Future Use a ‘combo’ to estimate the current future Call+Strike-Put=Future 2.05+17-2.10=16.95 Future

Trading Long W/ Contango Recall that VIX futures are normally in contango That creates almost a second ‘negative’ theta as the Future converges to Cash However, the VIX has a favorable forward skew that trader can take advantage

Trading Long When using options to trade a higher VIX, typically the most favorable call is one that is slightly ITM or ATM An even more favorably trade is a call debit spread Buying a call that is ATM and selling an OTM call can allow for bullish verticals with favorable risk reward

Bullish Call Spread With VIX at 14.25 we can buy a Oct 17/22 call spread for less than .40 That is a call spread that pays 4.60 against a .40 dollar bet, for a near the money spread

Short Puts thie Remember, the VIX has a floor Thus the credit might be small VIX Put selling has a positive expectancy Combo of Short Puts and Short SPX Puts Spreads is a viable strategy

Vol Premium SPX VOl, is greater than market vol (vix premo) VIX futures are greater than settlement VIX (VX futures premo) VVIX vol is greater than VX future realized vol (VIX options premo) Despite the postive skew in VIX options, the net off all the Vol Risk Premium makes short call spread extremely favorable over the long term

VIX Call Sale Sell aprx 30 days to ex 2 pts above future collect at least 10% of strike width buy back spread for .05 (or short option) When VIX is at extreme lows, wait When VIX has made large move higher, cut size down, look for a drop (dont sell into rallies) better to sell vix 16 coming from 20 than vice versa

Trading Short w/ Contango While a trader usually has contango in his or her face when trading from the long side, one typically has the ‘wind at their back’ when trading from the short side This makes outright puts a favorable trade The further OTM the put is, the lower the IV Trading a long put will have favorable characteristics in a falling and stable environment

Bear Puts Notice a 2 point vertical costs as much as a 6 point vertical on calls The outright can be more favorable

Playing VIX Pops 12/28/12

12/31/2013

Bear 1 by 2 Again a floor is in VIX, this 1 by 2 has a BE of 11.85

Bear 1 by 2

Hedging The VIX is actually as many of you know, a hedging vehicle The calculation is directly related to how variance swaps trade in the OTC market A variance swap is an OTC trade where each side bets on how much the market might move over a specified period of time Based on actual Realized Vol While there are many circumstances that SPX or SPY are better at hedging a long equity position there are times where VIX does a better job

Why Use VIX What is the major issue of using SPX as a hedge? Stick strike issues If I buy a VIX 18 dollar call expiring in May, it is highly unlikely that the VIX will be able to move far enough out of the money that the strike no longer hedges When the SPX moves from 1750 to 1950 the hedge stops working

The Stick Hedge In July the VIX was hitting all time lows The Oct future was around 14.60 SPX was around 1974 Notice how it has moved to today The future is up 2 full points What has the Jan 2015 1950 put done? 1950 was 68.70 Today: take a guess????

SPX 67 dollars! Congrats you spent a bunch of money for the hedge not to work at all Despite the VIX being up 4 points AND the S&P down 30

VIX On July 2nd the Oct VIX 15 calls are trading 1.65, (we need about 8-9 to cover 100 SPX deltas) Today where are those calls trading? 2.15! The hedge made .50 per contract, about 450 dollars per 100 deltas of SPX A the peak WED it was more like 700 i

VIX If one was using a nearer term hedge, the VIX could have potentially worked even better depending on the timing Basically, VIX has a sticky strike, if one is hedging FAR out in a bull market, it is going to work better If the market stays around where it is, more a wash (although probably a winner) It loses if the S&P take a quick drop i

Smart Hedge Recall how I explained to trade VIX long from a speculative side Why in the world would I treat a hedge trade any differently The only major difference, I might leg the call spread on a hedge trade buy long when VIX sub 13 sit and wait when the underlying rallies a point, sell the spread DO NOT GET GREEDY, a point should make the hedge close to free i

Smart Hedge 2 Looking to hedge AFTER a major move? Hey how about a bull 1 by 2 in the second month contract Will be over priced will have too much skew Will need to be taken off in short order DO NOT SIT ON A HEDGE THAT WORKS IN VIX i

Summary VIX options have unique characteristics Each has their own underlying IV and VIX are correlated Bear and bull plays have different structures Play the spikes

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