For the average investor there are three, not so attractive ways to go long on VIX:

1. Buy VXX Exchange Traded Notes
2. Buy VXX call options
3. Buy VIX call options

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The first one, buying VXX,  is the simplest—anyone with a brokerage account can do this.   Be aware that the VXX will definitely lag the VIX index (think molasses), and it is not suitable as a long term holding because the people in the VXX shop are forced to continually shift from short term to longer term futures contracts, usually at unfavorable rates.
Some VXX closing values compared to the VIX index:

• Its first day of trading, 30-Jan-09, VXX closed at  104.58, the VIX index closed at 44.95
• December 2009 VXX had dropped to 38, a  63% decline, compared to the 50% drop in the VIX index value to 22.
• 8-September-2010, VXX closed at 19.25, VIX at 23.25.  It’s now higher than VXX.

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This is a substantial tracking error.  Given its dismal track record it is surprising that VXX usually trades over 10 million shares a day.   I think the allure comes from its reliable negative correlation with the equity markets.  If SPY has a significantly down day, you can be pretty confident VXX will have a good day–unlike some investments like gold.

On June 1st 2010 options on VXX were introduced and became almost immediately successful.   I think retail investors flocked to them because they lacked most of the VIX option weirdities–such as European exercise, different expiration dates, VRO based settlement values, and greeks that are general wrong.   VXX options have an actual underlying, which avoids the perpetual confusion associated with VIX index, and the VIX options where volatility futures are the actual underlying.   Recently weekly options on VXX were introduced, so investors have even more VXX option choices.

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The third one, buying VIX options, is no more difficult than buying equity options.  Unfortunately they too lag the VIX index because they are also tied to VIX futures, not the VIX index.  In addition to their sluggish performance, they have these other issues:

• The bid / ask spreads are huge!  Never pay what is offered, use limit orders and split the bid/ask prices (e.g., if the spread is 3.40/3.80 and you want to buy, offer 3.60 or 3.70 with a limit order.)  More on trading VIX options here.
• The VIX options are European exercise, unlike most equity options—practically this means the VIX options will predictably match (approximately) the VIX index, only once a month—the moment they expire.
• The posted greeks (delta, gamma, etc.,) are almost always wrong.  See more here.
• Like all options, their premium value erodes with time, especially as you approach expiration.

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If you want to go long on the VIX index you are probably hoping to speculate on its big swings, or you are trying to hedge your portfolio against big, sharp declines.    If you want to speculate, be prepared to move in a  hurry—the VIX drops quickly once the market angst subsides.   Most of the action is over in a few days.  If you want to hedge, frankly I’d look elsewhere (e.g., long term out of the money puts), because these two choices are expensive if you are trying to get enough leverage to really protect a long portfolio.

XXV booked its first million share day on its 15th day of trading—August 6th, and average volumes have been running over 400k.  You have to imagine that Barcalys is happy with this new product.

XXV actual performance vs theoretical percent move or true short, click to enlarge

Usually getting the prospectus for a new ETF or ETN takes a Google search and a couple minutes of browsing.  The prospectus for Barclays’ new XXV inverse volatility ETN proved to be a much more elusive search—it didn’t show up in the top 20 hits.   Reading through the fine print of the XXV Fact Sheet provided this pointer for web access:

Before you invest, you should read the prospectus, prospectus supplement, pricing supplement and other documents Barclays Bank PLC has filed with the SEC for more complete information about Barclays Bank PLC and this offering. You may get these documents for free by visiting EDGAR on the SEC website at www.sec.gov.

Even finding the prospectus on EDGAR proved to be frustrating.  My search in Edgar’s company search for  ”Barclays Bank PLC”  resulted in a  lot of hits, but 20 minutes of clicking did not yield anything XXV related.    I finally did an  EDGAR text advanced search with XXV as the text and Barclays Bank PLC as the company to find the XXV prospectus and a few other related documents.

I have only started to dig through this 66 page document, but so far the most interesting aspect of XXV is its “Automatic Termination Event”—which liquidates your position if the intraday indicative note drops to $10 or less.   I don’t know of any other ETN or ETF that includes a built in stop loss order like this.   XXV is effectively a short of VXX, and as investment writers are fond of reminding us, a short position can theoretically result in “infinite” losses.  The people at Barclays have decided to block the infinite losses scenario  by limiting an investor’s potential maximum loss to be whatever they invested minus around $10 per share.

Somewhat sobering, the prospectus finishes the section on Automatic Termination Event with:  ”If the historical frequency of precipitous increases in market volatility persists, it is highly likely that an automatic termination event will occur”.

This is probably not an investment that you want to buy and hold…

With a whopping 10 days of data it looks like the shorts probably have it.   The percentage chart below has the sign inverted on the XVV results to make it easier to compare to the VXX moves.   If XXV is trying to be an inverse percentage fund its performance on the 26th and 30th was pretty poor.  On the other hand, it was pretty good performance in order to emulate a VXX short.

The second chart shows the difference in results between 100 shares of XVV bought on its first day of trading (19-July-2010) vs a simulated inverse VXX percentage style fund.

VXX vs XXV daily % moves, click to enlarge

Comparison of a true VXX short vs XXV, and inverse % style VXX approach, click to enlarge

It is interesting to conjecture how the VXX options will behave compared to their cousins, the VIX index options.

Similarities:

• Both based on S&P 500 volatility futures
• Will show a strong reversion to baseline behavior when the market is behaving itself—the VIX index and VXX will tend to quickly drop to a lower “stable” value
• Will not track the peaks of the VIX index.  The volatility futures are tied to future values of volatility (duh) , rather than today’s value—so they tend to move significantly less, although pretty much in time synchronization.  The values jump at the same time, just not as much.
• The spread between bid and ask will be wide for at least in-the-money calls

Differences

• VXX options expire  on Saturdays—the same day as most equity/ETF options, not on the Wednesday that futures expire for that particular month.
• The VXX settlement value will probably be the closing value of VXX on the Friday before the options expire, not the  once per month VRO settlement value used by the VIX options—which is rarely if ever the same as the Wednesday opening print of the VIX index.
• The VXX, and hence VXX options will be sensitive to the relationship between the current and next month futures prices on volatility.  The VXX shifts its weighting between these two months on a daily basis.  Generally this results in a price erosion force on the VXX  relative to the VIX index because the further out month is usually higher in value than the close in month (called “contango” in futures parlance)
• The implied volatility of  the VXX options should generally be lower than the equivalent VIX options, because  it is the mix of two months of volatility futures, not one like the VIX options.   For example, for June expiration the volatility should be about the same the day after the May VIX options expire (because both sets of options are tied to June futures) , and the VXX option volatility should decrease relative to the VIX options as the time remaining on the June options decreases and the VXX picks up more weighting in the July volatility futures.
• The VXX options quotes/option chains will be easier to find and their greeks will be correct.   VIX index quotes are not even available on Google finance.   Yahoo finance gives VIX index quotes (^VIX), but not option quotes or chains.   And everyone, including Schwab and Fidelity report incorrect greeks for VIX options– LIVEVOL being the only exception I am aware of.
• The VXX options have American style exercise rather than the VIX option’s European style exercise.  The European style exercise was necessary on the VIX options because the VIX options and VIX index are only guaranteed to line up once—at expiration time.  The VXX and its options will naturally track each other well, so American exercise is ok.  Practically this won’t be a big deal.

In the “no free lunch” category, I predict attempts to use VXX/ VIX options to take advantage of VXX’s historical price erosion compared to the VIX because of futures contango without taking volatility risk will not be profitable.    This might manifest  itself as large bid/ask spreads for some strike prices.

Summary

I think the VXX options will be popular with the retail crowd.  They behave like regular stock options with the same expiration dates, settlement practices, American style exercise, and available/accurate quotes, option chains, and greeks.  I think the pros will contue to use the VIX options because they provide a purer play on S&P 500 volatility.

For more information see:

VIX and More

Daily Options Report by Adam Warner — if your head isn’t spinning yet…

CBOE news release

• CBOE (Symbol VIX, enter symbol in field on left side of the page), check “list all options” radio button
• LIVEVOL (Symbol VIX or ^VIX)  Registration required.  This site has the correct greeks for VIX options, the only site I’m aware of that gets them right.
• freerealtime.com (Symbol VIX.X)
• Yahoo provides VIX index quotes (symbol ^VIX) and in sometimes options quotes.  As of May 23, 2010 these option quotes are not available.

The VIX option symbols listed in the CBOE option chains have an “-e” at the end.  This indicates they have a European style exercise.  Unlike typical stock options which are American style option exercise, the VIX options can not be exercised before their expiration date.

Exercising options early can be attractive if the underlying stock is distributing a dividend, or if you feel the market is not properly pricing the option.  For example, if stock XYZ was at 101 and you hold a 100 strike price call option for stock XYZ that the market bid is 0.50, you would be better off exercising the option and selling the stock.  Your net, ignoring commissions, would be 1.0 per share in this case rather than the 0.50 would have received by selling the option.

This “below intrinsic value” option price might seem an unlikely situation, but with VIX options it happens all the time–usually when the VIX index has had a nice little run up.  VIX options should really be called “VIX Futures” options–because they are based on VIX futures, not the calculated “cash” index updated-by-the-minute that is called the VIX.  Usually if the VIX index runs way up, the futures lag significantly–leaving the options lagging lower in the same way.

The “Futures” was probably left off by the marketing types because they figured (correctly) that it would scare folks off.  Their only defense is that there is one point at time, the moment when the futures and options expire ,that VIX and the VIX options are forced into close alignment.   This alignment point is captured with the monthly VRO quote, which is close to, but not exactly the same as the VIX index value on expiration Wednesday opening.     Given the nature of the VIX index / VIX futures relationship the VIX options folks had no choice but to use European exercise for their options. VIX options are cash settled.

For related posts see:

• How to go long on the VIX index
• How to go short on the VIX index

Created a bear spread on VIX options today.   Betting on VIX going down is forecasting that the market in general will be flat or positive.  I sold-to-open June VIX 16 calls at 10.26, bought  June  VIX 32.5 calls at 1.88 for a net credit of  8.38.  I was able to approximately split the bid/ask prices with my combo order.   At the time of the order the spreads were approximately 10.00 / 10.60 on the June 16 options and 1.80/1.95 on the June 32.5 calls.  Going with the published bid/ask prices leaves money on the table.

The VIX cash index was around 28.5 at the time my order filled.   I initially tried to go short on VXX, but Schwab had VXX in the “hard to borrow” category this morning.   I suspect lots of people were trying to short the VXX today.   I went with June options rather than May because there are only 7 days left on the May VIX options–I wouldn’t be surprised at all to see one more down leg in this correction.    I expect the June options will move much down much slower than the VIX index as the market moves away from fear mode.

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