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Volatility Is Like the Weather


The VIX statistic and what it means.


A commenter on my blog yesterday shared this great analogy for VIX options. Pretend for a sec that instead of volatility, this thing anticipated weather, and play along:

An analogy to VIX futures contracts might be a hypothetical futures contract on the temperature at a specific time at a specific location. Assume, for example, that today is July 1 and you are trading a futures contract on the temperature at noon in Anchorage, Alaska, on January 1. You might estimate that "it will be cold," and maybe the futures will be trading at "-20," indicating an expected temperature of 20 degrees below zero at noon on January 1 in Anchorage.

The question is, if the temperature in Anchorage on July 2 rises to record lows, say 70 degrees above zero, how will this affect the price of the January 1 futures contract? The answer is "not very much, if at all." Why not? Because the temperature on July 1 in Anchorage is most likely unrelated to the temperature in January. "The temperature in July could rise and fall back and forth between unprecedented levels. Such changes, however, would most likely not change the expectation for the temperature on January 1. Only as January 1 approaches will changes in temperature begin to affect futures prices. If it were 10 degrees above zero on December 25, for example, it is unlikely that the January 1 temperature futures would remain near -20. However, if the temperature changed on December 26 and 27, then the price of the January 1 futures contract could be expected to follow those changes more closely. "You'll also see that there are opportunities in the VIX options to buy calender spreads for credits.

An options trader might look at that and say "a calender spread for a credit? That's free money!" Wrong. Because the differences in front/back month options, and European expiration, there are about a hundred things that can go wrong. Like if you're long an OTM calender put spread, and the front month expires in the money, and the VIX is drained, then yes, the markets will anticipate mean reversion and the euro expiration back-month puts will run at such a hefty discount that you'll lose money paying out the front month shorts upon assignment

And it gets even worse. VIX is a statistic that measures "the market" estimate for actual volatility on the SPX over the course of the ensuing month. So in the example above, you are not just guessing January temperatures in July, you are guessing what some future consensus of weathermen will predict for January weather. And again, you're making that guess in July. Put another way, the VIX itself is a *guess* as to the *weather* for the next 30 days. A VIX future guesses what that guess will be on the day the future expires. A VIX options guesses the volatility of that guess between now and when the guess is actually made.

So I can't emphasize the complexity of this product enough. If you can't avoid it, at least stick to the nearest month so that VIX on the screen at least bears some correlation to the futures/options you are playing.

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