Paper Trade -- Delta neutral SPY IV drop capture

Simulated trade to capture pre-holiday volatility drop in SPY

SPY 92.95 1000 shares

SDS 54.09 (2X short S&P500) 430 shares (see delta neutral calculation below)

SPY July 91 Call 2.97 Delta .68 IV 23.24

SPY July 92 Call 2.29 Delta .6 IV 22.07

SPY July 93 Call 1.69 Delta .51 IV 21.39 (this is the one I selected--has the most premium)

VIX 25.06

DISBA 27.45 (Deep ITM Split Bid/Ask VIX) -- VIX true underlying price

VXX 66.86 DISBA/VXX = .4105

Net Debit = 1000*92.95+430* 54.09-1690 (Sell 93 July calls) = 114519

In the absence of other market dynamics the $SPX option IV drops significantly on Friday, or the day before a long holiday weekend. If the options are not expiring that weekend any sort of trade needs to be delta neutral, otherwise the normal move of the underlying would dominate the P/L of the position. This position should be delta neutral--but would need to be rebalanced if the underlying moves.

When figuring out what the SDS position remember that the SDS tracks 2X the percentage move not the point move of SPY. Since the 93 call is providing -.5 of the delta and the SPY is providing +1.0 delta we need another -0.5 delta to be neutral. I think it is easiest to do the SPY --> SDS conversion in dollars -- we need the equivalent of 0.5*1000 = 500 short shares of spy for the hedge, which is 500*92.95= 46475. Since SDS gives us a 2x move we divide that by two = $23237, and then we divide by the SDS price, 54.09 to get the number of shares to buy = 429.6, rounds to 430 shares.

End of Day 1 results

The market sagged some. Final prices:

SPY 92.39 off 0.56 (0.6%)

SDS 54.8

93 July Call 1.45 Delta .446 IV 22.5 (up 1.11)

VIX 26.22 (up 1.18)

DISBA 27.60 (up .14)

VXX 67.76 (up 0.9)

Paper value of the position at day end was $114504 (down $15) -- the hedge worked well! It looks like the time decay of the option contributed about 0.05 per option $50 total to this result. In addition the SDS was short about 0.2% in achieving the ideal 2X move. Finally the move away from delta neutral as the call delta shifted things to a net loss for the day.

Because of the market action the option IV went up, overwhelming the time delay factor that would make it go down. The IV on the option moved almost as much as the VIX -- which is what you would hope would happen, this is the intent of the VIX index calculation, to show the IV on S&P500 calls.

To adjust the hedge: We now need -(1-.446) = -0.554 in SDS to balance the lower delta of the option. 554*92.39= 51184.06, divide this by 2 and divide by the SDS price of 54.8 = 467 shares of SDS.

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.