Trading the VIX/Futures Spread (Part II)

A few days ago I suggested that the gap between the front month VIX futures and the VIX spot had gotten a little high. The gap has closed a bit, but I wanted to explain in more detail the suggested trade because I received quite a few questions regarding it.

Futures Spread Collapsing

The VIX index is a measure of 30 day implied volatility. The CBOE calculates the VIX as a weighted average of next term and near term S&P 500 option volatility. As volatility increases and decreases the number of options used in the VIX calculation expands and contracts, so the portfolio of options used to replicate the VIX is ever changing which makes the index non-investable. In order to *try* to replicate a long position in the VIX, you want to go long a representative portfolio of 2 month or less (preferably 30 day) puts and calls while delta-hedging the position daily. My suggestion was to delta hedge a simple straddle at the front month or the front two months of S&P 500 options. I deem that a sufficient replication for going long a representative version of the VIX. Will it follow the VIX exactly? No. But in trading I always tend to error on the side of simplicity – K.I.S.S.

The second question was regarding the VIX futures. Why are we going long options against the VIX futures? Should we be using VIX options instead? No. My point is to trade the basis of the VIX index versus the VIX futures which are an expectation of what the VIX will be in the future. When the August 2010 VIX futures trades at 27.3, it is saying that on expiration Wednesday morning, August 18th, we expect the VIX to be at 27.3. If you short the VIX futures at 27.3 today and the VIX is calculated at 30 on that Wednesday morning, then you will lose 2.7 points. So the point in my suggestion was to enter into a “pairs trade” in which you go long a representation of the VIX index and short the front month VIX futures because the gap between the two was at a historically wide level. This position would be pseudo hedged if you had $1,000 of long vega on the S&P 500 options that you purchased against every 1 VIX futures contract that you shorted.

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Posted in Derivatives, Markets, Trading Ideas.

Tagged with Contango, Futures Curve, pairs trading, VIX calculation, VIX Futures, VIX index, VIX Options.

2 comments

By SurlyTrader – July 22, 2010

Public Wages Out of Control

This might be an absolute tail anomaly, but this latest outrage out of California highlights a major problem. Bell city has a population of 38,000 residents and resides in Los Angeles County, California. The population is mostly Hispanic with a per capita income of $24,800 which is much lower than the nation’s average of $32,800. What does the head of such a city earn? $800,000!

The Los Angeles Times reported July 15 that Chief Administrative Officer Robert Rizzo earns $787,637 — with annual 12 percent raises — and that Bell pays its police chief $457,000, more than Los Angeles Police Chief Charlie Beck makes in a city of 3.8 million people. Bell council members earn almost $100,000 for part-time work.

I bet they have nice fat pensions as well… Get out your pitchforks. You can read more here.

Posted in Politics.

Tagged with unbelievable.

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By SurlyTrader – July 21, 2010

Trading VIX Versus VIX Futures

Despite a jittery equity market, the VIX has fallen towards the lower end of its 3 month range. Unfortunately for those trying to capitalize on a falling (uninvestable) VIX index, the tradable VIX futures do not seem to care what the more widely watched VIX index does. The front month VIX futures contract closed at 28.5 while the VIX closed at 23.93. That leaves a spread of 4.57. Since the inception of these futures contracts, that gap has never gotten wider than 5.23 which occurred on July 14, 2009.

4.57 is on the upper edge of the VIX/VIX Futures gap

So how do you actually trade the closing of this gap? Go long one month ATM calls and puts, delta hedge that position and short the equivalent vega position in the front month futures contract. As with all trades, the only place where you will find a perfect hedge is in a Japanese garden.

Posted in Derivatives, Markets, Trading Ideas.

Tagged with Contango, Options, vega, vix, vix curve, VIX Futures, vol hedging, Volatility.

6 comments

By SurlyTrader – July 20, 2010

The Jobless Recovery in Perspective

“We have hit bottom and are on the upswing.”

– James J. Davis, Secretary of Labor.

September 12th, 1930

You often hear that the Great Depression was not so bad if you had a job. That is probably of little humor to the millions of people who are currently unemployed. The sad fact is that despite seeing positive GDP growth and a rebound in corporate profits, the labor market “recovery” has been nothing other than painful. After over two years we are still 5 1/2% in the jobs hole, or worse than the peak of the 1948 recession.

Where is the jobs recovery?

What is disheartening is not just that this job recovery has been so terrible, but that job recoveries in general have gotten slower. If you follow the different recovery paths, you see the turning point later and later in the recovery cycle. The key question is whether the slow jobs recovery has to do with the depth of the recession, the length of unemployment benefits, the cautious outlook by corporations (cyclical demand), or whether there has been a structural shift in the US labor markets. My bet is that the vast majority of the problem has to do with a structural shift. The jobs lost in commercial and private real estate are not coming back anytime soon and the homebuilders seem to know it. Where do the individuals who are unemployed and used to work in construction turn? Many manufacturing jobs have already moved overseas and many more in the automotive industry have been hacked as well. It certainly makes you wonder if at some point we made a wrong turn. With such a large budget deficit, trade deficit, and unemployed workforce it is hard to see that we have set our country up for success.

Let us all hope that innovation sparks the re-purposing of this economy, otherwise we might just give way to the European model of socialist stagnation and entitlement.

Posted in Economics, Markets.

Tagged with economy, jobs, unemployment.

4 comments

By SurlyTrader – July 19, 2010