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One
of the newest option products to appear in our universe as an options trader
is the option series designed to trade the volatility index (VIX). The VIX is
a measurement of the implied volatility of the S&P 500 index.
To review
quickly, the implied volatility of an options series is reflective of the
aggregate market opinion of the future volatility of a given underlying
asset. In terms of the Volatility Index, the price is the current market
opinion of the future volatility in the S&P 500 Index over the next 12
months.
As are all
attempts to predict the future, this value does not always reflect accurately
the actual volatility as it plays out prospectively, but at a practical level
it is the best we can do. As sage philosophers have long noted, “the
future isn’t what it used to be.”
The importance
for traders is the well established and generally
known inverse correlation between prices for the given underlying and the
measure of implied volatility, in this case our VIX value. What is typically
less known is the fact that levels of implied volatility correlate even more
closely to the velocity of the price move of the underlying asset in question.
Because rapid
price moves occur far more frequently to the downside, it follows that the
general correlation between price and implied volatility is inverse. A
fundamental characteristic that underscores the logic of this trade is the
strong tendency of the VIX to revert to its recent mean. While this is not a
certainty, it is unquestionably a high probability outcome.
For
professional traders, much of the focus of hedging activity has recently
moved to establishing protective positions in this index rather than such
older techniques as buying out-of-the-money protective index puts. However
there are some well recognized pitfalls in this approach that lay in wait for
the retail trader not aware of some of the nuances inherent to this approach.
One of the major
risks in trading this product derives from the fact that both options and ETFs
are based on the value of VIX futures. Because there is no mandatory
mathematical linking of the value of these futures in the several available
expiration months as is routinely present in the options series with which
most traders are familiar, a huge and not generally recognized risk exists.
The founders of
one of the major retail options brokers have repeatedly cautioned that the
single major cause of irreparable account ‘blow ups” they
witnessed were the result of time spreads, aka calendar spreads, in this VIX
product. This is the result of the ability of the various expiration months
to move without mutual correlation in response to significant market events.
The result of
this observation is the practical consideration that time spreads in the VIX
must never be traded. No calendar spreads must ever be considered when
trading the VIX. Failure to follow this admonition will subject your account
to risk far beyond what you consider to be remotely possible. Simply put,
“Don’t do it.”
So what trades
in the VIX carry reasonable and definable risk? A wide variety of trades
including those with both defined and undefined risk is feasible. Such trades
include verticals, butterflies, condors, and simple long and short options.
Long time
readers know that I strongly prefer to structure positions to include at
least a component of positive theta within my trades. Positive theta simply
means that the spread has a component that will benefit from the passage of
time. Let us consider a modified butterfly position; this position is
commonly termed a broken wing butterfly.
First, let us
review the current chart pattern of the VIX:
 
As can clearly
be seen in the chart above, the VIX is at multi-month lows, and perusal of
even longer term charts confirm this value is at multi-year lows. Given this
situation, the probability of a move upwards toward its recent mean is
overwhelmingly high.
In order to
give sufficient duration to our trade, I would like to look at a butterfly
structure approximately 3 months into the future in order to allow for mean
reversion of the VIX.
The P&L
chart for our broken wing April put butterfly is displayed below:
As can be
clearly seen, the trade structure has no upper bound of profitability and the
risk to the lower side is the total amount paid to establish the butterfly.
As such, this is a defined risk trade that will profit from a reversion of
the VIX to its mean.
We welcome you
to try our service to see more high probability trades that capitalize on
current market conditions. Over the past two years, the service’s
performance track record has steadily beaten the S&P 500 Index while
taking significantly less risk.
JW
Jones
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