Bull Spread on VIX options -- more like a Bear (with result)

For quite a while I have been looking at the possibilities of creating a pseudo buy-write on the VIX by buying VXX, and selling VIX call options. The less than perfect tracking of the VXX to the VIX makes this an iffy proposition, especially if I am trying for a lower risk, lower premium position.

While investigating this approach, I noticed that the split of the bid/ask prices on the deep ITM VIX options tracks the underlying next month VIX futures contract more or less exactly. It turns out this is not surprising because this is the underlying instrument for the VIX options.

Trading the VIX via options has some unusual aspects. The VIX will never go to zero while the market is still standing (a zero value would mean no volatility in the S&P 500), and has not been below 9 in several years. When the VIX does spike up, it is a given that it will not stay up there forever. Life, and the stock market have a way of returning to normal after big scary events--so does the VIX. This returning to normal phase has been playing out in this market cycle since the big fear phase that started a year ago.

I created a bull spread, long on the deep ITM option, and short on the 22.5 options. I looked at the 25 options, but the break even point was the VIX at 23.90, which was not something I was comfortable with. A continued big rally could drop it below that. The VIX 22.15 breakeven value for the 10 / 22.5 spread felt better. The numbers below show the bid/ask spreads and the midpoint between those values:

VIX Aug 10 16.90/17.50 mid 17.20

VIX Aug 22.5 4.90 / 5.20 mid 5.05 BE for bull spread 17.20 - 5.05 = 12.15 equivalent to VIX at 22.15 (year low 23)

VIX Aug 25 3.20 / 3.40 mid 3.30 BE for bull spread 17.20 - 3.30 = 13.90 equiv to VIX at 23.90 (barely a point below the level when I entered the order)

I made the initial offer at a 12.15 debit, which was a 50% split of the current bid/ask prices. That order didn't execute so I upped it to 12.20, and it filled almost immediately. This reinforced my observation that you can usually trade the VIX options around the midpoint of their wide bid/asked prices.

Since the short term VIX usually moves in the opposite direction of SPY, a bull VIX spread really is a bear spread from an overall market perspective. But even more fundamental, this spread is a bet on volatility not dropping too rapidly in the 22 days left on these option when I bought them. The VIX dropping below 22.2 would be ugly.

The initial debit order I put in at 12.15 --and overall 0.35 premium. It didn't go , I changed it to 12.20, and it executed almost immediately.

The overall return is about 2.5%, assuming the market doesn't go crazy--not bad for a 22 day investment.

16-Sept-2009  Sept VIX option expiration 

The VIX opened at 23.28 today, so this position closed out with both my 10 (long) and 22.5 (short) options in the money--as desired.  The recent rally made me a little nervous, but the 22.5 level never seemed at too much of a risk.   The Oct options don't expire until Oct 21st (35 days from now).   Today I'm not comfortable betting that the VIX will stay above 22.5 for that long, so the 20 options will be my focus of attention.