Everybody’s Talkin’ VIX Curve

• Posted by Adam Warner
• on July 14th, 2010

And a happy Bastille Day to All!

MKM Partners takes a look at the steep VIX that we’re all yapping about

Although spot VIX has declined sharply over the last couple of weeks to close at 24.56 yesterday, its low since mid-June, longer- dated maturities have barely budged. This upward-sloping volatility term structure is approaching its steepest level in recent years (measured between spot VIX and the six- month future), likely reflecting imbedded skepticism in the aftermath of the May 20
volatility spike.

This condition is typically not sustainable, and we think it must be resolved either with the short end of the curve snapping back toward recent elevated levels or the long end drifting lower. Given our view that spot VIX will remain downward-trending over the intermediate term, we expect the latter scenario to play out. This suggests that the term structure of VIX will flatten while the curve will gradually shift lower toward its position earlier in 2010.

From a volatility trading perspective, this dynamic can be exploited in single stocks via long gamma, short vega strategies (i.e., buying short maturities to sell long maturities delta-neutral). Directional investors who are long stocks with steep term structures and who are bullish over the short term could similarly buy near out-of-the-money calls in one- or two-month tenor while selling further out-of-the money calls around six-month tenor. This creates a leveraged overwrite that provides short-term upside exposure in parallel with the long stock, while committing to selling those shares at a higher level.

It’s funny, I wrote something up for Investor Place (the former Options Zone) about playing this. You clearly do want to buy “short” and sell “long”, my issue though is that “short” is that it’s not a real arb in that long and short dated options are two very different animals. I do think the longs are a sale, but am not so convinced shorts or a buy.

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