Monday, June 29, 2009

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.

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