Understanding the Underlying of VIX options

If you have paid any attention, you have noticed the price of VIX options does not track the VIX index well. The reason is not a secret--the market makers for the VIX options use VIX futures to hedge their risks--since there is evidently no good way to do this with the VIX itself. While the VIX futures do a decent job of matching the VIX when the market is going sideways, they seriously lag the VIX the scary down days that really spike up VIX values. Observe the difference between the index and the July 2009 future since last September:

While starting and ending around the same level, the VIX hit peaks in the high 80s while the Futures max'd out in the mid 40s. Since the VIX options makers would probably have been using shorter term futures earlier in the year this is not a totally fair comparison, but you can see the dyamic--and it is not a good one if you expect the VIX options to track the VIX.

I have only been watching this for a few weeks, but it looks like you can get a pretty good feel for what the short term VIX futures contract value is by splitting the bid-ask spread of the deep in the money VIX call option with a strike of 10. For example, this option closed at 17.20/17.80 today --splitting the bid-ask would give 17.50, add 10 to reflect the strike price and you get 27.50. The July VIX future closed at 27.45 -- I rest my case....

The VIX itself closed at 25.35 today, the option prices above translate into astronomical IVs if you assume that the VIX is the underlying. If you assume the VIX future value, you get reasonable IV values (e.g. 0 for the bid).

The VXX ETN, is also based on VIX futures, so this suggests that the VXX and VIX options should track well--better than the VIX/VXX ratio. The VIX/VXX ratio on sideways market runs around .39, but can vary from .37 to .42 on volatile days--not a very good hedge. The VIX Future / VXX ratio tends to run around .41 to .415 --a more stable ratio. I haven't been watching this for very long, but the VIX futures/VXX definitely looks more like an underlying for the VIX options than the VIX itself.

With a rational (and well behaved) underlying, writing calls on VIX options with VXX to hedge the upside moves looks more reasonable. For example, earlier today, selling July 30 calls would have given about 1.40 per contract, Hedging at 41 shares of VXX per contract (67.92) would have cost $2785 for a net debit of $2645 the VIX futures were running around 27.85, the VIX was at 25.6. Given the volatility drops of the last few days, I think the odds are that the VIX will start to climb a bit.

The dangers of this position include a sustained drop in VIX--you only have a small 1.4 insurance policy on this eventuality--best to put this position in play when you think volatility is going to go up. If VIX stays stable or goes up you have a $140 gain on a $2645 investment (5%) with a 3 week duration before the option expires --assuming of course the VXX behaves like the VIX option underlying.... If the market goes strongly down, then the VIX options will go ITM and you should be able to close out the buy-write earlier with most of the profit. This is nice, because this buy-write gives you an upside when the market goes down--contrary to the somewhat bullish orientation of standard equity based buy-writes.

25-June SPY Buy write

Bought SPY at 91.35 Wrote July 91 calls SWGGM at 2.38, Debit of 88.97 Messed around a bit putting in a debit order, even though the two products only had spreads of .01. Ended up doing sequencial limit orders at market price. The delay cost an additional debit of around .05 or so.

Buy-writes on SPY quarterly options --ROQ series and XLK

Update --SPY/ ROQ buy-write: SPY upticked to above 92 after I took this position and the options were assigned at expiration. I'm looking for the next quarterly option opportunity in September.


Back in the market today. Definitely some downside risk, but we are off the recent highs enough I felt like I should be getting back in. By accident on Fidelity's option chains I noticed a set of options expiring at the end of June, not the usual expiration date. It turns out these are CBOE quarterly options with the end of March, June, September, December expiration. Other than the spreads being a little wider than regular SPY options, everything else looks pretty equivalent. The premium on SPY 90s was about 1.05 (~1%) for options that have 7 calendar days to run--compared to July 90s with maybe 2.2 for options that have 25 days to run--not a tough decision to make. The spread on the options was wider, maybe .05, but I was able to almost spit the bid-ask with a buy-write debit order.


Debit buy-writes are executed by humans, so the execution time is underwhelming, but if the market is not too volatile I use them because you can get around the retail restrictions on option pricing (.05 cent increments above a certain level) and you don't have to stress trying to do two sequential orders. Overall Debit was 88.30, SPY at 89.35, SPY 90 Call ROQFL at 1.05


My June XLK options were assigned this last weekend at 18--fine by me. XLK obliged by dropping to around 17.5 this week so I jumped back in. The XLK buy-write was a $17.29 debit order--which also was within a penny of splitting the bid-ask. It took about 20 minutes to fill the order, so I don't think I left much on the table. Bought XLK at $17.55 Sold to open XLKGR July 18 at $0.27.

The Weekly Friday Swoon of VIX

I'm watching the traditional drop of the VIX on Fridays. SPX Options prices are dropping as the time time decay value of the weekend is being incorporated--this is reflected as a drop in their IV, even though it is really a time effect.

As is typical the VIX call prices are not dropping--perhaps they are tied to the VIX futures which I'm guessing don't care which day of the week it is. As a result the VIX option IV values jump up across the board--no combination/spread opportunities present themselves.

Assuming nothing much happens over the weekend then Monday the VIX will bounce up, and the absolute value of the VIX options will stay about the same--and their IV will drop down again. No opportunity to buy cheap options on Friday and sell them dear on Monday. Even though VXX is designed to track the VIX, it will have none of this nonsense and doesn't follow the weekend wiggle.

It strikes me that in this scenario the VIX is not representing volatility-it is exhibiting some 2nd order effects of SPX options trading--namely that they don't trade on the weekends/holidays. So two days of the week -- Friday and Monday the VIX is being jerked around an artifact.

For the purposes of analysing a potential pseudo buy-write of VXX and Deep ITM VIX calls then it seems like I would be better off looking at the ratio of the next to expire 10 VIX call to the VXX. Since the bid-ask spread is always wide on these, splitting the difference seems reasonable. The value for today, around 2:30 EDT was around .415 for this ratio, while the VIX/VXX ratio has dropped below .37 (it was as high as .415 early this week).

June 09 SPY dividend capture -- the aftermath...

All of my SPY calls were called last night from my trades two days ago I'm left with my option premium (0.33) as the results of my efforts. .33/90.67 = 0.36% for two days of investment and pretty low risk--not bad... If only SPY dividends were more often than 4 times a year! A nice feature of this approach is the addition of the dividend to lower the break-even point in the negative scenarios. If the market drops such that the equity price drops below the stike price of the short call, then you have the dividend value that is captured to lower your break even point.

SPY dividend capture

For the latest SPY ex-dividend information see this post on sixfigureinvesting.com

FAQ -- Why are the bid-ask spreads so wide on VIX options?

In addition to their sluggish tracking of the VIX index itself (VIX options below intrinsic value) the In-The-Money VIX options also tend to have relatively wide spreads (.5 or .6 is quite common). Equity option spreads tend to be more in the .1 to .05 range, with more liquid options dropping to only a .01 bid-ask spread.

I am not familiar with the ins and outs of option market making, but I suspect the wide spreads are due to the lack of a direct VIX investment / ability to short a direct VIX investment. The market makers are not speculators--they want to make a relatively small amount of money regardless of where the VIX moves and absent an inexpensive - low risk way to do that hedge they widen the spread to compensate.

You don't have to pay the ask/bid price. I have always been successful knocking at least .1 off the stated price, so if you can afford to be patient you can try splitting the ask/bid spread with your limit order and then if that doesn't work, cancel the order and offer a little more incentive to the buyer-seller.

Update VXX to VXI tracking

On June 3rd I posted on the apparent stable ratio of VIX to VXX -- .39 since about the beginning of April. This ratio appears to be holding. The chart below shows VIX/100, VXX/100, and VIX/VXX. The VIX/VXX (blue line) seems to be holding steady at an average of .39, the average for the last 30 days, and the last 60 days.

I divided the VXX (yellow) and VIX (purple) by 100 so they would scale in a range similar to th VIX/VXX. The intra-day tracking of the two is not as tight, the VXX tends to lag the VIX by a few minutes and the ratio varies between .365 and .41.

Below is just the VIX/VXX ratio with a 15 day simple moving average.

Things definitely settled down in April.

7 points ITM / 6 days to go / 5 options

11-June-09

The market was up at opening, and the VIX was down as you would expect--fairly sharply at around 27. As is their practice, the VIX calls behaved sluggishly, not moving much--and as a result the premiums on the deep in the money calls became high--the bid IV was over 500! The 20 June calls, with 6 calendar days left on them had $100 of premium on bid with a spread of around .5 to .6, which is typical (the July calls had $300). I sold 5 June VIXFD 20 calls (at 8.0) and bought the June 40 calls (0.1) for a net credit of 7.90. I then bought 200 shares of VXX at 72.84 to hedge the position. The VIX/VXX ratio has been running at around .38 but it felt silly to buy 190 shares. The net debit on the position was 10618, not including commissions, and if the VXX hedge is perfect the profit at execution will be $450, or 4.2% (again, excluding commission). We will see how it goes.

I tried splitting the bid / asked spread with my option order and then dropped the credit by 0.1 intervals, but the offer didn't execute until I had dropped to within 0.1 of the bid offer on the ITM call. I didn't wait very long with each order, but I didn't get the feeling that they were going to bite.

Time to catch a SPY dividend? 19-June-2009 ex-dividend date

It is almost ex-dividend time again for SPY -- according to the CBOE the ex-dividend date is the 3rd Friday in December, March, June, and September. So it is June 19th this year (June options expire on the 20th). My guess is a dividend of around $0.50 per share -- so with SPY running around 94, that is around a 0.5% payout. Small potatoes, but you only need to be invested for 1 day (buy on the 18th or before). Of course SPY will likely open down around the dividend amount on 19th, so it is a wash at the straight buy-the-stock-collect-the-dividend level.

Approach A: I have successfully played this by selling deep in the money calls on SPY with a premium equal or greater than the dividend amount. The calls are usually exercised and you have your money as premium, rather than dividend. However this month, I have been very nervous about a market correction (to make it a "W" instead of a "V" shaped bear market bottom) so that approach is not very attractive.

Approach B: Another path is to sell in the money (ITM) calls much closer to the expiration date, again with premium close to the dividend payout and hope they expire in the money and you get assigned. If they don't expire in the money you run the risk of the market dropping the next Monday and wiping out all your crafty plans. By the way, you can't sell your SPY shares in the after-market on that Friday even if the calls are out of the money--had my wrist slapped on that one. The calls don't expire until Saturday and selling the underlying on Friday creates a naked position you probably aren't authorized for. Closing out the position close to market end might be a pretty cheap solution, or perhaps buy OTM calls to create a cheap bull spread and then sell the SPY. Commissions costs are definitely a factor here.

I've looked at trying to short the SPY wanna-be IVV and the short and ultrashort funds but the pros are way ahead of us on this one--there is no way to beat them this way.

I'll probably do approach "B" this year, but I might pass because of the downside risks.

VIX -- "The Fear Index" FAQ

See my new blog post for an updated version of this FAQ.