Re-Visiting the VIX

As many of you know, the CBOE Volatility Index (VIX) options are not based on the cash, they are based on the futures. In the past, this made trading the VIX options tough as the spread between the VIX cash that everyone in the media pays attention to (and many traders misguidedly think the VIX options are priced from) and the VIX futures. Since 2009, the VIX futures have usually been trading at a premium of at least $2.00 in the front month. This means that when the VIX cash read 25.00, the VIX futures might be trading 27.00 or 28.00. This effect continues to exist today and produces three main problems:

1. The VIX Futures have a slow premium decay that traders need to deal with. As the futures get closer and closer to expiration the futures would slowly converge with the cash.

2. The front month future only correlates with the VIX cash at about 50%-60%, thus the Options deltas are only about 50%-60% as correlated to the VIX cash.

3. The spreads between futures can change based on demand.

This is a problem as it makes hedging with VIX options against a large implied volatility pop a little more difficult. One has to take into account when to enter a VIX hedge (my estimates suggest four to six months out makes the most sense) in order to avoid decay. You also have to figure out where they are least likely to get burned by the futures spreads, and choose the right amount of options to correlate the VIX hedge to the grouping of trades it is mean to hedge.

Recently though, I have noticed some cracks in the VIX term structure. Namely, the spread between the front month future and the VIX cash has tightened significantly. This suggests either, traders think there is less risk of a pop in volatility, or with implied volatilities lower, are choosing to hedge with downside puts over VIX calls and futures.

Why do you care about this? With the March spread tightening to a premium of about 1.5%, the March futures are likely to correlate better with the VIX itself. This is a great thing if you think that we could see a temporary implied volatility pop in the near future. Personally, I do not see a major pop in volatility, but I do see an incremental increase. I envision the VIX rallying to 18.50-19.50 range, as the S&P 500 falls close toward 1300-1310 or so. I do not think we see anything in the 1200s anytime soon. As such, it may be cheaper to actually buy the VIX calls or a call spreads. I like call spreads because of the skew curve of the VIX (the volatility structure is more like that of an oil contract than an SPY contract).

With the March VIX future trading at around 17.80 or so, I would look to buy the VIX March at-the-money 17 calls and sell the 20s. If we get an incremental increase in implied volatility this trade will do great, yet, because of the structure of implied volatility and options, I am paying parity against the futures for the spread ($0.80 for the spread that is).

If I entered this trade, I would punt if it fell to a value of $0.45 and look to sell if I the value increased to $1.25, or so.

Trade: With the March VIX future trading 17.80, buy to open VIX March 17 call for $1.85 and sell to open the March 20 calls at $1.05.

At the time of publication, Mark Sebastian held a position in VIX.

Mark Sebastian is COO and Director of Education for Option Pit Option Mentoring. Sebastian is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. Along with his role directing the path of education for Option Pit, Mark is currently the Director of Risk for a private hedge fund. He started the popular blog Option911, which is now the Option Pit blog. Sebastian has been published nationally on Yahoo! Finance, is a featured contributor for TheStreet's OptionsProfits, SFO, OptionsZone and is the managing editor for Expiring Monthly: The Option Traders Journal. Mark has a Bachelor's in Science from Villanova University.

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