Vix-spy Put Hedge

8/8/2019 Vix-spy Put Hedge

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www.optionstrategist.com 1-800-724-1817 [email protected]

Using Volatility (Derivatives)In Your Option Trading

Presented byLawrence G. McMillan

The Option Strategist 2010 Chicago Trading Forum

April 23, 2010


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McMillan Analysis Corp.A Derivatives Firm

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Todays TopicsUsing Volatility Derivatives

Direct StrategiesContrary StrategiesHedged Strategies

Cartoon credits:

The New Yorker OptionsXpress Book of Cartoons


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Implied Volatility (IV) A guess at volatility during the life of the

option

When IV is low, options are cheap but when its high, they are expensive

When IV rises, the option gets more expensive(Causes: large price drops, takeover rumors,

FDA hearings, etc.).


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$VIXCBOE Invention 1993:

using 4 series of $OEX optionsrenamed $VXO in 2003 conversionCreated by Prof. Whaley, Duke Univ.

Changed in 2003:uses strips of two nearest-term $SPX

options, to create an average 30-day volatility


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Usually, implied volatility triesto predict the stocks volatility,

But at the extremes,

Implied volatility reflects themood of the public

And can thus be interpreted as acontrary indicator

Volatility As A Contrary Indicator


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Implied Volatility Buy SignalImplied Volatility spikes during severe declines

(investors panic and buy puts)

A spike peak in IV in such a situation

Is a valid buy signal

Mostly useful in the broad market indices ($SPX)But also applies to stocks and futures


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IV Buy Signal:IMPLEMENTATION:

WHEN IMPLIED VOLATILITY PEAKSTHE UNDERLYING IS READY TO RALLY

So either BUY THE UNDERLYINGor SELL NAKED PUTS

Stop: a new high in IV


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$VIX Buy Signals 1997-1999


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Rating $VIX Buys 1997-1999


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$VIX Chart Early In The Bear Market


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$VIX: 2007-2009


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Current $VIX Chart


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History of $VXO


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$VIX compared to Actual $SPX Vol


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Trading Volatility Directly:

New Volatility Products

Futures on $VIX

Futures on Variance (actual volatility)

Options on $VIX

New Options on $VXN & $RVX, etc.


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NewOption

ProductsHaveBeen

Listed

Regularly


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VIX Futures: Details One point move in VIX = $1000 move in futures

Margin: $8,800 initial ($7,000 maintenance)

Settlement: a.m. settlement on Wednesday

Settlement day: 30 days prior to next option expiration

Always a WednesdayExample:

$SPX Dec options expire 12/18/2009 (3 rd Friday)

30 days back: 18 in December + 12 in November

Nov has 30 days, so 12 days back is (Wed) 11/18/2009


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The change in VX futures trading pattern since Aug 2007 is obvious.

VIX Futures Trading History


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Recent $VIX Futures Trading


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A Problem With $VIX Futures?

Both speculators and hedgers havesometimes been disappointed withmuted movements in $VIX futures

when $VIX makes a move.To counter this, stay short-term

since $VIX is a 30-day measure.


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Term Structure of Options


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VIX Movements #2: 7/16/07 - 8/16/07

7/16/07 8/16/07 % change

$VIX 15.59 30.83 +98%

Aug VX Fut 16.70 30.60 +83%

Nov VX Fut 16.98 22.38 +32%

Better, but near-term is the far better hedge

This time, $VIX traders were not predicting a quick return to lower volatility, and once again they were right.


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VIX Movements #3: 9/03/08 - 10/10/08

9/03/08 10/10/08 % change

$VIX 21.43 69.95 +226%

Oct VX Fut 23.10 57.50 +149%

Feb VX Fut 23.82 31.53 +32%

Futures trading at large discount for a lengthy time.

Eventually it was bullish.


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Term Structure Sept-Oct 2008


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Term Structure After March 09 Low


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Term Structure, Fall 2009


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Recent Term Structure


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$VIX Futures Predict BroadMarket Price Movements

In the previous slides, traders of $VIX futuresand options might have been frustrated becausethe futures didnt move the full amount, but

thats because the futures had already discounted the market move to come.


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$VIX Futures As ATechnical Indicator

The front month* (nearest-term) VIX futuressometimes develop a large premium or

discount with respect to $VIX itself.

A large premium is bearish for $SPX.

A large discount is bullish for $SPX.

*: change front month with a week to go until expiration


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A series of $VIX Futurespremiums or discounts

is often a longer-term market signal

Discounts in a falling market are a

bullish setupsPremiums in a rising market are

bearish setups


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$VIX Futures As ATechnical Indicator

Huge VIX futures premium in late December foretoldof stock market problems on the near-term horizon:

$SPX fell 230 points in less than a month


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$SPXvs.

$VIXFuturesPremium


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Actual vol vs. Implied vol (Futures)


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Term Structure as Predictor

Spread between two front monthsSpread between months 1 & 3

Shape of the term structure

It is the change of these items that is important


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As the curvemoves from

positive slope toflat to a negative

slope, $SPXshould be rising.


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Trading The Term StructureTrading calendar spreads: high leverage,

good profit potential.

9/17/07 9/24/07 10/5/07

Oct fut 24.33 19.70 17.92

Nov fut 22.83 19.91 19.26

Spread +1.50 -0.21 -1.34

Gain: +1.71 ($1,710) in one week or

+2.84 points ($2,840) in 3 weeks

Margin: $625 (first three months)


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More On Trading Term Structure

Extremely High Leverage

Risk Is Unlimited(futures spread may invert)

May be better implemented withETNs or Options


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Options On Volatility ($VIX) Options on $VIX Index ( not on futures)

Launch date: 2/24/06

Just like options on $SPX, $OEX, etc.

Expiration date: 30 days prior to nextmonths $SPX option expiration

To price them with a model, they must betreated like futures options


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$VIX OptionsNew Product: launched 2/24/06

Cash-Based options on $VIXAre priced like futures options, however

Open interest is large: 2.19 million (11/20/2007)


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$VIX Call Options October 10, 2008

$VIX: 69.96Oct Nov Dec

25 Strike Calls 31.60 13.70 10.00

Seemingly incongruous pricing, at face value.


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$VIX Call Options October 10, 2008

$VIX: 69.96Oct Nov Dec

25 Strike Calls 31.60 13.70 10.00

Futures 56.71 38.30 33.78

Ignore $VIX: the underlying for each optionis the corresponding futures contract.

------------


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Some $VIX Option StrategiesBehave Differently

Calendar SpreadsNo longer have limited risk.

Option 9/10/08 10/10/08Oct 25 call 1.75 31.60Nov 25 call 2.15 13.70

Paid 0.40 for calendar spread.Loss is -18.30 on 10/10/08!!


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Hedged StrategiesUsing $VIX Derivatives

Spread: SPY vs. $VIX options

Calendar spread using $VIX futures


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A Hedged Strategy When $VIXFutures Are Out Of Line$VIX: 23.60 May VX futs: 26.10

Could try to short $SPX because of the premium onthe futures

Or.could hedge: short $SPX, short $VIX.Buy $SPX puts

Buy $VIX puts

In a ratio of roughly 1 SPY for 2 $VIX*

*: ratio depends on volatility of SPY and VX futures


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VIX/SPY Spread Concept$VIX and SPY move in opposite directions,

So buying calls or puts on both is a hedge.

The primary impetus for the trade is a discountor premium on the $VIX futures

If discount: buy calls on both;

If premium: buy puts on both.

In essence, its a long straddle with an edge in

the $VIX options; with no edge you could buySPY straddles (or $VIX)


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$VIX/SPY Profitability

If the Discount/Premium disappears, the spreadshould profit.

1) If $VIX moves to the futures price, the SPYside of the trade should profit

2) If the futures move to $VIX, the $VIX side of the trade should profit.


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How Much Discount/Premium?

Traditionally +/- 2.0 points or more

The bigger, the better


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Why Use Options, Not Futures?

Options give you 2 ways to profit:1) Convergence

2) Large price movements

Example :next slide

Wh O i ? E l


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Why Options? Example:

From the 17 th to 29 th Discount widened from -9.61 to -14.03,

But strategy made money because of volatile movement andthe fact that options were used


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How Many Options To Buy?

General intermarket spread formula:Ratio = (v 1 x p 1 x u 1 x 1) / ( v 2 x p 2 x u 2 x 2)

where v = underlying historic volatilityp = underlying priceu = units of trading (100 shares/ option) = option delta (if using options)

How Many Options? Example


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How Many Options? ExampleIf using slightly in-the-money options on each

side, the deltas will be roughly the same, soformula simplifies to:

Ratio = (v 1 x p 1) / ( v 2 x p 2)where v = underlying historic volatility

p = underlying price

Price 20-day HVOct VIX futs 34.0 82%SPY 112.0 50%

Ratio = (34 x 82) / (112 x 50) = 0.50So buy 2 $VIX calls vs. 1 SPY call


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When to Exit or Adjust1) If convergence occurs, then exit (i.e.,

$VIX and the futures trade at more or lessthe same price)

2) If profits arise from movement, re-centerthe position in some way:

a) roll the profitable side up, or

b) Take a partial profit (trailing stop), or

c) Exit old position and re-establish new onewith new calls on both


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Adjust: ExamplesIn The Option Strategist, on Oct 2 nd we:Bot 13 $VIX Oct 32.5 calls @ 3.70

And Bot 5 SPY Oct 112 calls @ 5.90

Two days later:VIX calls: 9.80; SPY calls: 2.70

Adjust: Sell 3 VIX calls

One week later:VIX calls: 20.50; SPY calls: 0.05

Adjust: roll VIX calls up to Oct 50


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What Can Go Wrong?

Divergence: possible over the short term

$VIX decline can hurt SPY calls in a rally

Failure to adjust can be costly


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It Still Sets Up!Thursday, April 15 th :

$VIX: 15.89

May futures: 19.30 (+3.41 premium)

Buy 2 $VIX May 21 put: 3.10

SPY: 121.29

Buy 1 SPY May 124 put: 3.60

Other $VIX Option Strategies


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Calendar spread with limited risk:Instead of :

Buy Nov 40 call, Sell Oct 40 callor A Futures Calendar Spread



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Rather, use LONG options on BOTH sidesBuy Nov 35 call, Buy Oct 45 put, for example



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Rather, use LONG options on BOTH sidesBuy Nov 35 call, Buy Oct 45 put, for example

Max. loss is now limited to what was paid for options.Can also make money even if no convergence.A purer Term Structure play.


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Calendar Spread Alternative9/10/08

$VIX 24.52

Nov 20 call 5.00Oct 27.5 put 4.30Combo: 9.30 DB to buy


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Calendar Spread Alternative9/10/08 10/10/08

$VIX 24.52 69.96

Nov 20 call 5.00 17.70Oct 27.5 put 4.30 0.00Combo: 9.30 DB to buy 17.70 CR to sell

Profit: 8.40


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Calendar Spread Alternative9/10/08 10/10/08

$VIX 24.52 69.96

Nov 20 call 5.00 17.70Oct 27.5 put 4.30 0.00Combo: 9.30 DB to buy 17.70 CR to sell

Profit: 8.40

Whereas Nov-Oct 25 call calendar lost -18.30

Futures spread: long Nov, Short Oct would have lost -18.41!

Volatility of Volatility (Skews)


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Volatility of Volatility (Skews)

Skew Strategies


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Skew StrategiesForward Skew:

Call Ratio SpreadPut BackSpread

Horizontal Skew:

Dangerous in $VIX options

$VIX Options Call Ratio Spread


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$VIX Options Call Ratio Spread

Forward Skew Trade:

$VIX: 22Buy April 25 call: 1.80

Sell April 27.5 call: 1.25Sell April 32.5 call: 0.60

Total 0.50 credit

Upside Breakeven: 35.50

The Newest Volatility Product:


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$VIX ETNsTwo Barclays iPath ETNs

VXX: $VIX Short-Term Futures Index

Blended average of front 2 $VIX futures months

VXZ: $VIX Mid-Term Futures IndexBlended average of months 4 through 7

Both reflect the daily percent gain or loss in each Index

VXX much more liquid than VXZ

No options on these products

VXX & VXZ: ETNs


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Therelationshipbetween thetwo reflectsthe general

term

structure of $VIX futures

History of $VXO


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$VIX Hedging is Dynamic

Better than buying $SPX puts:protection is dynamic

If you buy $SPX puts and market rises, your protection is virtually worthless

If you buy $VIX calls and market rises, your protection is still viable

$VIX Hedging Is Cheap


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$VIX Hedging Is CheapAccording to a well-known study, a portfolio consistingof 90% $SPX and 10% $VIX outperforms $SPX in bothup and down markets. Later studies suggest 20%.

So you only need to hedge 10%-20% of your portfoliosNAV, assuming it performs in line with the broadmarket.

Buy slightly out of the money $VIX calls, one or twomonths out, and keep rolling them.

The 10% Theory of $VIX


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How Many $VIX Calls To Buy?


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Hedge 20% of your NAV Assume NAV = $100,000 on 9/16

VIX Oct 30 call = 4

You buy $20,000/(30x100) = 7 calls

Stock market down 26% ($SPX 1210 to ~900)

Oct $VIX Futures: +125%; $VIX +131%; Oct 30 call = 27

NAV: -$26,000 loss

7 calls x $2300 profit = +$ 16,700 gain

You lose -$9,300 = your deductible (9.3%)


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The $VIX CollarBuy $VIX out of the money calls

And Sell $VIX out of the money puts

If $VIX falls (presumably market rises),You will lose on the downside,

Thereby reducing your overall profits

But not as severe as an $SPX Index shortcall which caps all profits.

The Future?


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Product Current Open Interest$VIX futures 58,861$VIX options 2,778,878

Variance futures 26

New: $VIX on oil (USO): $OVX,$VIX on gold, (GLD): $GVZ

$VIX on Euro FX (FXE): $EVZNext: $VIX on rates.

My prediction: eventually, most active stocks will eachhave its own $VIX with listed options! So, e.g., you

can hedge the volatility of IBM directly.

Volatility Projection


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