Towards the end of June, when the spot VIX was around 12, we placed our preferred long VIX futures trade with an eye on September. Here was the trade and rationale:
TRADE – Sell the VIX (11.96) Sept 13 put and buy the Sept 15/19 call spread for a 0.10 debit
– Sell 1 Sept 13 put at 0.65
– Buy 1 Sept 15 call for 1.50
– Sell 1 Sept 19 call at 0.75
Break-Even on Sept Expiration:
-Profits up to 3.90 between 15.10 and 19, max profit of 3.90 at 19 or above
-Loss of 0.10 between 13 and 15, structure expires
-Further losses below 13 in linear fashion
Trade Rationale: This trade structure only loses more than 0.10 on a VIX print below 13 on September expiration. Our plan, as usual, would be to sell this structure if Sept VIX futures move into the high teens or near 20 at some point over the next 2.5 months. We will be especially vigilant about covering the 13 put on a bounce given our loss on the last VIX trade. For those who do not want to be naked short the Sept 13 put, one could buy the Sept 12 put for around 0.25, or the Sept 11 put for around 0.10.
Right now the spot VIX is checking in at around 16. The September futures are trading about 50c less that spot at the moment. Our structure is trading around 50c, which is intrinsic to where the futures are and 50c below intrinsic to the spot. There’s obviously alot of time before they expire so I wanted to discuss what happens to the position on moves from this point both near term and longer term as we get in September.
The way the structure works means that large moves in the spot VIX early in its expiration cycle means less to the gains and losses of the structure than large moves late in the cycle. This is no different than a multi legged structure in a normal equity but the VIX is more interesting and worth understanding.
The first aspect of the structure’s value is similar to equities but in reverse as far as skew goes. The VIX options trade like a commodity where the risk is a spike to the upside in prices. What this means is that upside calls trade at a much higher volatility than do downside puts. This is for obvious reasons. Like commodities, the VIX will always be worth something. The stock market would have to close for the entire month for that expiration’s VIX to go to zero. A commodity’s price will never go to zero, but a company can go bankrupt and its stock can be worth nothing. Because of that asymmetry, the VIX rarely gets below the 10-11 range even in the most boring of market cycles. However, the VIX can spike higher at any time with a market sell-off. So what you’ll typically see when looking at VIX options is a skew that looks like this:
Compare that to the SPY options and to see what normal skew looks like in equities:
What that shows is the volatility of each strike in the VIX goes higher to the upside and lower to the downside. Where equities are almost the opposite with puts below with much higher volaitlity than calls to the upside. (The tiny bit of skew to the upside calls on the right of the chart is simply on out-of-the-money calls that are dollar cheap and kept slightly higher just so they’re not sold too cheap by market makers.)
So that explains skew. The second factor to understand about VIX options is that unlike equity options that simply have one thing to factor as far as the underlying, the VIX options trade off of the relationship between the VIX futures and the spot VIX. The futures don’t track the spot VIX 1 to 1 as day to day movements in the spot VIX are too volatile to be trusted as far as where the index will settle in 1, 2 or 3 months time (I’m simplifying here, but that’s a good way to think about it). Because of that, the VIX futures will only track part of the day-to-day movement in the spot VIX, with extreme moves affecting the closer expirations on the futures more so than farther out expirations.
So if the VIX were to suddenly spike to 20 this week on another big down day in the SPX, the August futures will track a good portion of that move, the September futures slightly less, and the October’s least of all among those 3 expirations.
So what those 2 major factors mean is that the intrinsic value of our structure will be realized more the closer we get to September expiration and less so right now. On that theoretical spike to 20 in the spot VIX this week, our structure would gain, but not be worth anywhere close to 4 (which is its maximum potential value). That can most easily be seen in the current deltas of the position, which is about 45 (long) deltas right now. A spike higher to 20 would make those deltas increase, but the fact that the September futures don’t expire for another month and a half means that the futures that they trade are based on won’t be 20. They’d probably be closer to 17-18 at that point. But if that spike in volatility were to be sustained for a few weeks, the futures will slowly converge towards the spot, as well as the deltas of the position increasing towards 100 over time. Both of these factors work in an exponential manner as the time until expiration decreases.
So what this all means is we will have to have a gut feeling as to when to close or roll the position on any spikes in the VIX from here. That gut feeling needs to factor all that I’ve mentioned here with the main judgement being how long will increased volatility last, and what is the new risk reward of the position given all the factors at work.