Save Ferris

• Posted by Adam Warner
• on May 4th, 2010

Here’s another example of some VIX trading thoughts.

The best way to play the VIX is by buying and selling options on the VIX. These options trade at the Chicago Board Options Exchange. There are futures contracts on the VIX and other volatility indexes, and there are ETFs that track the VIX and other indexes. Trading futures is a riskier game and requires greater margin, which isn’t for the faint of heart. There are also problems with VXX and VXZ, the two exchange traded notes that are designed to mimic volatility. They don’t track their benchmarks precisely.

They actually do track their benchmarks just fine, it’s just that the benchmark is not what most think. VXX as we well know tracks a hypothetical rolling 30 day VIX future. Those futures almost always trade at a premium to “cash”, as well as an upslopiing curve (contango). VXX actually has no tracking error as far as I know, at issue is the structure of the product to begin with.

Instead of selling in May and going away, investors can buy calls on the VIX now, while it is trading near its two-year lows around 15.65. Buying calls on the VIX is a good way to hedge your existing portfolio against a spike in volatility, which would rise in the event of any out-of-left-field crisis and any significant market sell-off.

It does sound like a solid idea, buy VIX while it’s trading near the lows. Except VIX is way off those lows now. And you couldn’t actually “buy the VIX” near there anyway, even what it was at the lows. That’s because the futures, even the nearest month one’s, carried at least a $2 premium at the time, generally more. And VIX calls of course traded at a premium to that. Alas you would have made a good trade though, as VIX did lift enough, though as we noted at the time, the $5.30 lift in the VIX when it shot up on Goldman/Greece translated to a $2.30 move in May futures. So if you cherry pick perfect timing (in all fairness, that’s not at all what the writer does here) that’s your home run.

But here’s the bigger problem. You don’t know when the “out-of-left field” crisis will happen, so you need to just hold. You’ll get a nice win on that first day, but gains will diminish over time as VIX trading products do not actually capture much of the VIX blip. And the real downside is they’ll erode in value over time thanks to the premiums to “cash” to begin with. So unless you time very well, you’re way behind the 8-ball before you get that big win.

Another way to profit from the VIX is to “range trade” it. If the VIX trades in a range between 15 and 30, for example, you can buy calls on the VIX when it is low to profit when it rises. And, you can buy puts on the VIX when it nears the top of its trading range, in anticipation of it trading back down. This kind of trading is called “reversion to the mean” trading. That means that regardless of up and down movement, the tendency is for the VIX to revert to its historical average. From 1990 through 2008 the average VIX level was 19.49.

Oy.

Should I break the news that tradeable VIX products actually reflect said reversion to mean assumptions? That’s why, say, July trades at a $4 premium now. In fact that’s the whole reason why VIX is not a good investment vehilce.

You can go nearer month and capture a greater percentage of the VIX move, but at issue there is that you better get that move fast, because when it expires you merely cash out. That doesn’t seem the point of the post though as the gist is how to play “sell in May and go away” for the summer, and May expires in a week.

VXX has certainly done much better lately, lifting from 18ish to about 21. By all means trade this pup if spot opportunity, just don’t hold as a “portfolio hedge”, it will ultimately end in disappointment.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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