VIX Arbs

• Posted by Adam Warner
• on July 21st, 2010

Is the monstrous exposure of getting the title song on the Eclipse soundtrack worth….having to be on the Eclipse soundtrack? I guess….tough to argue with the Benjamins.

Oh yeah, where was I?

Surly Trader notes the mongo VIX futures premiums and has this trade idea out to August.

So how do you actually trade the closing of this gap?  Go long one month ATM calls and puts, delta hedge that position and short the equivalent vega position in the front month futures contract.  As with all trades, the only place where you will find a perfect hedge is in a Japanese garden.

He’s right (on the concept) and right (it’s not a locked trade).

Way back in the Neolithic Age or so (5 years ago maybe) the way to buy SPX volatility was to……buy actual options on SPX. If you thought volatility was too cheap, maybe you would purchase straddles or strangles. You would attempt to pay for the volatility by delta hedging as the index moved. Putting on that play is de facto buying *spot* VIX.

Now let’s say you go short actual August VIX futures against that. What can go right?

Well, best case is the actual SPX (or SPY) options are priced fairly. You roughly scratch on that half, and win on the August VIX short.  Or alternatively, realized volatility lifts and your SPX/SPY option play wins, while the Aug VIX roughly scratches. Or some variation of the above.

What can go wrong?

Realized volatiltiy stays here or declines and you lose on the SPX/SPY side by virtue of your not being able to delta hedge well enough to offset the daily decay. Meanwhile, the VIX and August volatiltiy futures stay strong. Remember August (or any future) snapshots an implied volatility assumption going forward, and that can decouple from backwards looking realized volatility.

I like his concept here, just know there are risks to it.

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.

blog comments powered by Disqus