How to Play the Volatility of Volatility
VIX products may now represent a good buying opportunity for hedging. Here's why.
- The VIX climbed from 15.50 to 22.75 in the six trading sessions leading up to last Friday, Dec. 28, 2012.
- The VIX has now plummeted to 14.40 in the past three trading sessions, including two consecutive days of 15%+ declines -- the first time that has occurred since the 1987 stock crash. And note that the retreat in implied volatility (IV) following the crash came from far higher levels in excess of 100.
- The VIX went from being 25% above its 10-day moving average last Friday to 15% below on Thursday. Both represent relative extremes and suggest there will be a reversion in coming days.
- The 10-day realized volatility of the VIX jumped to 140 while implied volatility of VIX options popped to 110%. The chart below illustrates the realized and implied volatility of the VIX and its options.
This "volatility of volatility" was the highest since the last 2011 debt ceiling sell-off.
Note the historical or realized volatility continued to rise even as the implied volatility plunged. This is due to the fact that volatility is not direction-dependent, but rather a measure of the magnitude of a move up or down. In contrast, implied volatility, which is the expectation for future movement, tends to get bid up on market declines, hence the VIX being referred to as a "fear index." So, as the market rallied, the premium paid for options declined. This is illustrated by the graph of historical volatility SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and the implied volatility of its options.
SPY: 3-Month Volatility Chart
Expectations of Reduced Volatility
The near-term concern was also reflected in the term structure of the VIX futures, which went into backwardation, or the front-month trading at a premium to later-dated months. For example, the VIX January futures were trading 22.50 while the February contract was 21.3 in December. The last time backwardation occurred was again during the 2011 debt ceiling in which the VIX climbed to the 45% level. The term structure has now returned to a more normalized cantango with January futures at 15.30 and the February contract at 16.60. But note, overall, the term structure is as flat as it has been in over a year with premiums running about 10% month to month. This compares to the 20-25% premiums that persisted up until the election.
For most of last year, VIX futures and its options had been overpriced as S&P historical volatility remained very subdued, hovering in the 11-14 range over the past six months. This meant that buying VIX futures or options did not provide a very good hedge against a market decline.
Implied volatility is now at a discount to historical volatility, suggesting that traders don't expect volatility to increase much in coming months. Given the looming wrangling over the debt ceiling, I think VIX products may now represent a good buying opportunity for hedging.
Don't Get Anchored to Market Price
My preference is to use the iPath VIX Short-Term Futures (NYSEARCA:VXX) and its options as the trading vehicle because the ETN has fewer quirks than the futures and its options, as discussed in Know Your Contract Specs: VIX Options Come With Quirks.
The VXX options saw IV spike above 100 but are now trading around 65%, which is the low end of the 52-week range. One of the advantages of using volatility as a hedging or portfolio-protection tool over buying SPY puts is that volatility has something of a floor as it rarely goes below 10 and certainly can't go to zero. This means that the VXX calls you buy (remember, volatility tends to increase as price declines) will not move too far out of the money even if the market rallies.
For example, with the VXX now trading around $28.80, one could buy the February $30 calls for $1.70 a contract. With the SPY trading around $146, you could buy the February $144 puts for $1.80 a contract. If the SPY were to rally 3% to $150 over the next two weeks, the SPY puts would now be $6 out of the money and worth approximately $0.90 contract. But the VXX will likely only decline 1.5%, meaning that the $30 calls would be worth about $1.50 a contract. More importantly is that now, even if a decline comes from a higher level, implied volatility will get a pop while the SPY puts, which are anchored to a further out-of-the-money strike, will require a very large decline to have a commensurate increase in value.
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