Going short on VIX?

There are several obvious ways to short the VIX index–with VIX options (buying puts, or selling calls) , or by shorting the VXX.  Unfortunately neither of these tracks the index itself particularly well.   Their highs are lower and their lows are higher.

One disadvantage of options is that they expire, where-as the VXX doesn’t.  An attraction of shorting the VXX (Schwab along with other brokers allows this) is its built-in tendency to decrease in value as the fund is forced to roll-over its about to expire volatility futures.    Futures on volatility with later expiration dates are usually more expensive (they have more uncertainty), so the VXX fund is forced to sell their about-to-expire futures relatively cheap, and buy replacements dear.  This explains why the VXX has dropped even more dramatically than the VIX over the last year.

If the market really does blow up and go into a full fledged meltdown, being short the VXX would not be a fun thing.   One possibility to mitigate that risk would be to buy out-of-the-money VIX calls as disaster insurance.    A key question with that strategy is the relationship between the VXX and the VIX calls–if the VXX moves a dollar, how much will the options move?   In the disaster scenario you only really care about the case when your out-of-the-money calls become in-the-money calls.  In that situation you want them to match the VXX increases closely to provide a good hedge.

The graph below compares the VXX with the April and May 2010 Call underlying.  I computed the call underlying by adding 10 to the VIX 10 calls–this usually conforms pretty closely to the volatility futures that the calls are based on.  The quality of the call data is pretty poor because the VIX 10 calls often don’t trade for days on end, but even with that you can see the VXX (blue) and the VIX (purple and yellow) options track each other reasonably well.  The orange trace is the VIX index itself, showing its more volatile character.    Based on this small set of data it looks like one VIX call option per 100 shares short VXX would provide reasonable disaster insurance assuming the overall position was not held more than a couple of weeks.  This will only hold true while the VXX value is similar to the VIX call underlying value.  As VXX continues to drop in value over time this ratio will need to be adjusted.

VXX vs VIX calls and the VIX index, click to enlarge