I keep an eye on the 6 month chart of VIX index’s relation to its Bollinger bands when I’m thinking of making a volatility trade—even when the trade I’m contemplating is a non-VIX related security (e.g., VXX, or XIV). Of course there is nothing iron-clad about it, but as an objective measure I consider VIX touching/near touching its 2 sigma lines to be an indication that the current phase of the market is ending.
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I bought $24 strike September VXX puts today at 2.83. With VXX you tend to not get as much mean reversion as $VIX, but the puts benefit from the typical contango that VXX suffers from.
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Vance,
The way I look at it, there are two dimensions to the profitability of XIV. One is that contango exists and that is a ‘bonus’ when holding an XIV position. The other aspect however is that purchasing XIV instantaneously makes you short on a weighted VIX futures position 30 days out. Now if there is a steep slope in the volatility term structure, that is good because I am likely to benefit from contango. On the other hand, if the weighted volatility futures are at say 16%, I would be really nervous because in an absolute sense I am buying XIV when volatility is dangerously cheap. So the weighted futures graph I want to see is the non-contango part of the XIV situation… this may be more important because we know that contango can disappear in the blink of an eye when volatility spikes and you’re holding onto XIV.
Andrew
Vance,
Thanks… Yes what I was talking about was the weighted average of the VIX futures that you essentially short when you purchase XIV. So this is not SPVXSTR:IND because that has the effect of contango and doesn’t add anything since it is basically VXX. If you jump into XIV because VIX has spiked, that can be a bad move if indeed the weighted futures didn’t move much. If you really wanted to sell high-buy low with XIV, it would be natural to look at this weighted average chart to see what you’re really getting paid and so it seems natural someone would chart this. As you say, it would be easy to chart since you can just use published futures data…
Andrew
Hi Andrew,
The index that XIV is based on (Bloomberg SPVXSP:IND) also includes the effects of contango.
I thought XIV used the same index at VXX, so this was good to learn, but this other index shows almost an identical behaviour (down 32.91% vs 32.94%) from 25-Jan-11 to 21-July-11. If you think about the internals of XIV they need to be buying (covering short positions) on the nearest month future and selling the 2nd month futures, so it will benefit XIV if things are in contango.
— Vance
Vance,
To determine the best time to buy XIV, I can certainly see it would be useful to look at a VIX chart with Bollinger bands. However, wouldn’t it be better to instead use a chart with the 30 day futures volatility (constructed using the appropriate weighting of the near and next month’s volatility futures contract daily values). After all, if the 30 days future volatility is elevated, that has got to be more relevant than if VIX is elevated, for purposes of purchasing XIV. Question is, does anyone publish such a chart?
Andrew
Hi Andrew,
I’m not sure if you want a chart of weighted 30 day volatility futures, or the volatility of the weighted 30 day volatility futures (volatility of volatility). You can see one flavor of the former as SPVXSTR.IND on Bloomberg SPVXSTR:IND. This is the index that VXX is based on, so if you plot VIX against VXX you will see the relationship–a muted, damped version of the VIX that includes the impact of contango. I think the Bollinger on the straight VIX gives a better picture of the ebb and flow of volatility.
If you don’t want the impact of contango included, just the weighted average of the two contracts, I don’t know of anyone that charts this. It would be pretty easy to construct this using published future data ( it can be easily calculated from deep in money VIX call option prices also).
If you want the volatility of volatlity, I’m not aware of anyone that charts this, but it is a fairly straightforward cacluation given the VXX or SPVXSTR.IND. If this is what you want, let me know and I can dig up some links I have on how to do it.
Recently I’ve been thinking about this general topic–the time relationship of VIX to the volatility futures. We refer to the VIX as the “spot”, or “cash” volatility index, but it is intended to give a prediction of volatility 30 days out–using a weighted combinations of SPX options from the current month and subsequent months. If we really want the instantaneous volatility we would have to look at something like ATM SPX option IVs, or some combination of the current IVs over the various strike prices.
The VIX value syncs up with the current month of volatility futures (VRO) the day when the current month futures expire–around the 3rd week of the calendar month. Since VIX is looking 30 days out, the current month of futures of volality is really looking out longer than that. When it becomes the closest-in future it is forecasting the volatility 60 days out, and it expires when it is forcasting the volatility 30 days out.
Since the index that VXX and XIV relates to is the weighted rolling average of the first and second months of volatility futures, it is not a 30 day estimate, but rather a rolling average of futures that are 30 to 60 days out and 60 to 90 days out –providing a constant 60 day estimate of volatility. Since it is further out than the VIX, it is reasonable that it is going to be less volatile.
— Vance
Vance,
I reread the article and it appears as though you do buy options on VXX. What makes you decide to do an options trade versus buying XIV?
Hi Baruch,
The thing I like the most about XIV is that there is no time pressure/time decay. If the market is in a bull phase then I’m confident that eventually my position will become profitable because of mean revision and contango erosion on the rolling short term futures. For short term trading I like that fact that intra-day XIV’s delta is always one, and now with the 10:1 reverse split the spread is one or two cents. I would be very nervous about using a market order on a VIX or VXX option, but I do it all the time with XIV.
The thing I don’t like about XIV is the capital risk–if we move into a bear market it could take a long time to get back to even. I’m actively looking for a insurance strategy that would protect me in this scenario, without costing too much.
— Vance
— Vance
Why do you prefer buying puts on VXX instead of selling calls? This way, you also profit from the time decay.
Hi Avi,
I’m not near brave enough to sell naked calls on VXX in the midst of a volatility spike. A VXX credit spread is a very reasonable trade, but if your long call is anywhere close to the current price (to reduce your worst case loss) there will be a lot of premium to pay, and your short call will probably not have much premium because you want to be significantly ITM to take advantage of a big fall-off in volatility. In buying near ATM puts I’m getting a reasonable delta that grows rapidly if I’m right and I’ve limited my max loss to the put value. If the puts have a long time to expire, I have revision to mean and contango on my side (as you would with a credit spread with the same time to expiration).
— Vance
Thanks for the informative, lengthy response. Why wouldn’t you do credit spreads on vxx using options after spikes?
Hi Baruch,
I think credit spreads on VXX or VIX to capture the downside of a volatility spike are very reasonable. I especially like the limited loss aspect of the spread–something that has been on my mind recently when I commit considerable amounts of capital to XIV. See my response to Avi for more thoughts on this.
— Vance
I’ve been trading vxx for a short while (6 months or so). I’m wondering how often do you trade vxx. and is it your bread and butter trade or do you do many different trades? How would you compare the risk reward of vxx to other trades that you do?
Hi Baruch,
It has been a long time since I have traded VXX directly. If it was easier to short I would probably do that, but instead I have been trading XIV. I don’t like trading the upswings in volatility because it seems like the action is very fast and can reverse directly quickly. I prefer to trade the decay in volatility once a peak has been reached. This mean reversion is pretty predictable plus I can also take advantage of the contango based erosion of VXX’s value. With XIV I typically look for a 2.5% move, which if I time it well is often within a day, or two. I use conditional orders to trigger when I hit my target price, which then executes a market order. I could just use a limit order, but I’m paranoid enough that I don’t like my orders visible to the market makers. Typically my market order fills at a slightly better price than my trigger price.
I don’t have any illusions that I can always reliably pick the market direction. If the market moves against me I’m generally comfortable holding onto my XIV positions. As long as we are in a bull market I believe that market direction plus contango will bring me back into a profitable position.
— Vance
Understood, thanks for the clarification. I wasn’t sure if there was some aspect to the VXX that I missed. Grats on your good call btw! Looks like you’ve already made a nice profit with today’s move.
Just out of curiosity, but why did you buy VXX puts instead of straight VIX puts? As I understand it, the VIX options are based on the near-term futures so should profit from the contango as well.
Hi Jim,
You are right, the VIX options are also based on volatility futures. If I had bought VIX puts with near equivalent duration (64 vs 60 days) the relevant futures would have been the Sept VX futures. VXX and the associated options on the other hand are always based on the two closest in futures, which until Wednesday will be the July/Aug combination. If the term structure is in contango for the 1st two months, then VXX is eroded because they are having to sell 1st month, and buy 2nd month futures every day. VIX options don’t have this particular mechanism at play, but the Sept VX futures will have theta like decay as they converge with the “spot” 30 day VIX index price. I suspect the market is pretty good at pricing in these factors. I doubt there will be huge difference in returns on VIX options vs VXX options for this trade.
— Vance