Friday, August 19, 2011

Touring the VIX Complex (VXX; TVIX; XIV)

From Schaeffer's Outside The Box Blog:
I mentioned last week that you can't trade the actual CBOE Market Volatility (VIX). However, you can trade an ever-growing stable of VIX- and volatility-based products. All of these instruments track volatility on some level, though none will exactly track the VIX.

With the recent market carnage, prognosticating and trading volatility has become all the rage again -- as has the inevitable confusion over how some of these pups actually work. In lieu of presenting a bunch of white papers, here's a little info on a few of the more popular VIX derivatives.

VIX Futures: These were the first-ever tradable VIX product. A VIX future expires every month, but they don't expire when everything else does. Rather, they expire 30 calendar days before the next S&P 500 Index (SPX) expiration. VIX went to this 30-day system because VIX itself proxies the implied volatility of a hypothetical SPX option of 30 days duration.

For example, we have "regular" SPX October expiration on Oct. 21. So, September VIX futures expire 30 days ahead of that, on Wednesday, Sept. 21. Since expiration is almost always on a Friday (though Good Friday sometimes pushes it to a Thursday), VIX expiration is almost always on a Wednesday. What gets confusing, though, is that sometimes it's the Wednesday just before regular expiration, and other times it's the Wednesday just after. "Regular" Septembers expire on Sept. 16 -- so, in this case, it's after expiration.
VIX futures cash-settle, meaning you get no delivery of anything, just cash in or out of the account based on the closing settlement price. How do they settle, you ask? It's a calculated value based on the opening quote of each eligible SPX option on the morning of VIX expiration. Importantly, it's NOT the first VIX quote that appears on the screen. At times, the VIX settles above the day's high or below the day's low.

Perhaps most relevant to you, the trader/observer, is what the VIX future represents. It is NOT a reflection of the volatility between now and when the future expires. It's actually the market's estimate for where the VIX will open on VIX expiration day. So, the VIX future is really just an estimate of where we will see the price on a specific day.

While VIX itself recently soared into the high 40s, VIX futures have not. Not even close, in fact. September VIX futures have more or less hovered in the mid-to-high 20s through all of the recent mayhem, meaning the market considers the latest VIX explosion to be a bit of a blip on the radar. It also means you can't actually sell VIX in the 40s -- at least, not via VIX futures.

Soon-to-expire August VIX futures do track VIX more closely, but still with decent discounts until very near the end. Unfortunately, they expire tomorrow and get cashed out, so you can only bet on a very short-term VIX move (not to mention gambling on the settlement price).

VIX Options: These vehicles came next in the VIX lineage. They're options on the corresponding VIX future, not the VIX itself. These options are European exercise, meaning you can't do anything with them until expiration. And they cash-settle, like the futures, meaning you do not get delivery of anything.
This all leads to some oddities to the naked eye -- such as September-dated VIX calls trading at huge discounts to the VIX itself recently. This, of course, is misleading. They were not at a discount to September VIX futures, which traded $15-$18 below VIX at times.

The important point to note is that VIX options, like VIX futures, priced in a steep decline in VIX off the highs. VIX shorts generated via futures or options will most likely benefit from VIX declines, just not as substantially as you might think....MORE
See also: "Trading the Actual VIX" at Outside the Box.