0. Hedging and Trading Strategies
Trading VIX Options
Hedging and Trading Strategies
Option Pit

1. What You Will Learn What Are VIX Options What Are The Characteristics
How are they different that normal options
What is the IV structure of VIX options
What Causes VIX options to move
Ways to play directionally using VIX options
Ways to Hedge

2. VIX Options
VIX options are NOT options on the cash VIX that is often quoted on TV
VIX options are options on the forward value of the VIX
This means they are an option on a volatility SWAP not on the VIX itself

3. Characteristics VIX options are European exercise
This means that they cannot be exercised early
Because of the European exercise, the underlying is a forward value of the VIX
Essentially, the underlying is the VX futures, not cash VIX
They have the same settlement procedure as the VIX futures

4. Volume Of Options
VIX options are extremely liquid and trade very actively
Trade is over hybrid and Open Outcry trading
Markets are generally
Relatively tight in the
Near term typically
wide (does not
Trade in pennies)

5. Activity

6. Volatility The VIX of VIX options is the VVIX Index
It often can seem very low relative to VIX, again this is because the option vol is more based on the movement in the VIX futures instead of the VIX options
Futures realized volatility is almost always significantly lower than the cash VIX

7. VVIX
VVIX will trade as low as the 60s in slow periods and can threaten 200 when the VIX is high and the market is in panic
This week, as the SPX was tanking and VIX was rising, VVIX was not rallying, what does that say?

8. VVIX

9. Volatility
Unlike the VIX relative to SPX, the VIX and VVIX are typically positively correlated
When the VIX is rallying, the VVIX is typically going higher
Especially when the VIX is moving from below its mean back toward its mean
When the VIX is popping and VVIX is not, that can be a sign that smart paper is selling insurance rather than buying it

10. IV of VIX Options

11. Term Structure
Unlike many equity products, typically near month implied volatility is higher than months further out
This is partially because each month has its ‘own’ underlying and the cash is not the true underlying for the whole set of options

12. Underlying Price

13. Term Structure
Each option trades vs the future that expires in the same month
Because each option has its own underlying, many firms to not offer a margining discount on calendars and time spreads
Because VIX options have different underlying it is entirely possible for a long calendar to trade for a credit
This is unheard of in normal equity options

14. Term Structure
Notice that may is trading at a large premium to June, but as the months move further out the Ievels begin to converge

15. Intra-month IV Structure
Normally Indexes have what is called a backward skew, sometimes called an investment skew
This skew is caused primarily by hedging activities and collaring

16. Backward Skew Notice that puts are more expensive than calls
This is caused by collar traders buying downside protection and financing it using upside calls

17. VIX Skew
Since the VIX is a volatility product, customers are more concerned about the product going UP more than they are worried about it going down (more similar to WTI than SPX)
Thus, the VIX has forward skew where calls are more expensive than puts
This contributes to VVIX positive correlation

18. VIX forward skew
Notice that upside calls trade at much higher IV’s than near the money and bearish options
Traders usually do not use a collar in VIX options, they typically simply buy calls

19. Underlying Price

20. Using Options
Recall that VIX options ATM strike is NOT the cash VIX level but the Futures
ATM for Oct is 16.4
ATM for Nov is 16.70
ATM for December is 16.89

21. Estimating the Future Use a ‘combo’ to estimate the current future
Call+Strike-Put=Future
=16.95 Future

22. Trading Long W/ Contango
Recall that VIX futures are normally in contango
That creates almost a second ‘negative’ theta as the Future converges to Cash
However, the VIX has a favorable forward skew that trader can take advantage

23. Trading Long
When using options to trade a higher VIX, typically the most favorable call is one that is slightly ITM or ATM
An even more favorably trade is a call debit spread
Buying a call that is ATM and selling an OTM call can allow for bullish verticals with favorable risk reward

24. Bullish Call Spread
With VIX at we can buy a Oct 17/22 call spread for less than .40
That is a call spread that pays 4.60 against a .40 dollar bet, for a near the money spread

25. Short Puts thie Remember, the VIX has a floor
Thus the credit might be small
VIX Put selling has a positive expectancy
Combo of Short Puts and Short SPX Puts Spreads is a viable strategy

26. Vol Premium SPX VOl, is greater than market vol (vix premo)
VIX futures are greater than settlement VIX (VX futures premo)
VVIX vol is greater than VX future realized vol (VIX options premo)
Despite the postive skew in VIX options, the net off all the Vol Risk Premium makes short call spread extremely favorable over the long term

27. VIX Call Sale Sell aprx 30 days to ex 2 pts above future
collect at least 10% of strike width
buy back spread for .05 (or short option)
When VIX is at extreme lows, wait
When VIX has made large move higher, cut size down, look for a drop (dont sell into rallies)
better to sell vix 16 coming from 20 than vice versa

28. Trading Short w/ Contango
While a trader usually has contango in his or her face when trading from the long side, one typically has the ‘wind at their back’ when trading from the short side
This makes outright puts a favorable trade
The further OTM the put is, the lower the IV
Trading a long put will have favorable characteristics in a falling and stable environment

29. Bear Puts
Notice a 2 point vertical costs as much as a 6 point vertical on calls
The outright can be more favorable

30. Playing VIX Pops 12/28/12

31. 12/31/2013

32. Bear 1 by 2
Again a floor is in VIX, this 1 by 2 has a BE of 11.85

33. Bear 1 by 2

34. Hedging The VIX is actually as many of you know, a hedging vehicle
The calculation is directly related to how variance swaps trade in the OTC market
A variance swap is an OTC trade where each side bets on how much the market might move over a specified period of time
Based on actual Realized Vol
While there are many circumstances that SPX or SPY are better at hedging a long equity position there are times where VIX does a better job

35. Why Use VIX What is the major issue of using SPX as a hedge?
Stick strike issues
If I buy a VIX 18 dollar call expiring in May, it is highly unlikely that the VIX will be able to move far enough out of the money that the strike no longer hedges
When the SPX moves from 1750 to 1950 the hedge stops working

36. The Stick Hedge In July the VIX was hitting all time lows
The Oct future was around 14.60
SPX was around 1974
Notice how it has moved to today
The future is up 2 full points
What has the Jan put done?
1950 was 68.70
Today: take a guess????

37. SPX
67 dollars!
Congrats you spent a bunch of money for the hedge not to work at all
Despite the VIX being up 4 points AND the S&P down 30

38. VIX
On July 2nd the Oct VIX 15 calls are trading 1.65, (we need about 8-9 to cover 100 SPX deltas)
Today where are those calls trading?
2.15!
The hedge made .50 per contract, about 450 dollars per 100 deltas of SPX
A the peak WED it was more like 700 i

39. VIX
If one was using a nearer term hedge, the VIX could have potentially worked even better
depending on the timing
Basically, VIX has a sticky strike, if one is hedging FAR out in a bull market, it is going to work better
If the market stays around where it is, more a wash (although probably a winner)
It loses if the S&P take a quick drop i

40. Smart Hedge
Recall how I explained to trade VIX long from a speculative side
Why in the world would I treat a hedge trade any differently
The only major difference, I might leg the call spread on a hedge trade
buy long when VIX sub 13
sit and wait
when the underlying rallies a point, sell the spread
DO NOT GET GREEDY, a point should make the hedge close to free i

41. Smart Hedge 2 Looking to hedge AFTER a major move?
Hey how about a bull 1 by 2 in the second month contract
Will be over priced
will have too much skew
Will need to be taken off in short order
DO NOT SIT ON A HEDGE THAT WORKS IN VIX i

42. Summary VIX options have unique characteristics
Each has their own underlying
IV and VIX are correlated
Bear and bull plays have different structures
Play the spikes

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