Vix-Spy Put Hedge

Using Volatility (Derivatives)
In Your Option Trading

Presented by
Lawrence 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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Today’s Topics
Using Volatility Derivatives
Direct Strategies
Contrary Strategies
Hedged Strategies
Cartoon credits:
The New Yorker OptionsXpress Book of Cartoons

Implied Volatility (IV)
• A “guess” at volatility during the life of the
option
• When IV is low, options are cheap

… but when it’s high, they are expensive
• When IV rises, the option gets more expensive

(Causes: large price drops, takeover rumors,
FDA hearings, etc.).

$VIX
CBOE Invention – 1993:
…using 4 series of $OEX options
…renamed $VXO in 2003 conversion
…Created by Prof. Whaley, Duke Univ.
Changed in 2003:
…uses “strips” of two nearest-term $SPX
options, to create an average 30-day volatility

Volatility As A Contrary Indicator
Usually, implied volatility “tries”
to predict the stock’s volatility,
But at the extremes,
Implied volatility reflects the
mood of the public
And can thus be interpreted as a
contrary indicator

Implied Volatility Buy Signal
Implied 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

IV Buy Signal:
IMPLEMENTATION:
WHEN IMPLIED VOLATILITY PEAKS

THE UNDERLYING IS READY TO RALLY
So either BUY THE UNDERLYING

or SELL NAKED PUTS
Stop: a new high in IV

$VIX Buy Signals 1997-1999

Rating $VIX Buys 1997-1999

$VIX Chart Early In The Bear Market

$VIX: 2007-2009

Current $VIX Chart

History of $VXO

$VIX compared to Actual $SPX Vol

Trading Volatility Directly:
“New” Volatility Products
Futures on $VIX
Futures on Variance (actual volatility)
Options on $VIX
New Options on $VXN & $RVX, etc.

New
Option
Products
Have
Been
Listed
Regularly

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 Wednesday
Example:
$SPX Dec options expire 12/18/2009 (3rd Friday)
30 days back: 18 in December + 12 in November
Nov has 30 days, so 12 days back is (Wed) 11/18/2009
VIX Futures Trading History
The change in VX futures trading pattern since Aug 2007 is obvious.

Recent $VIX Futures Trading

A Problem With $VIX Futures?
Both speculators and hedgers have
sometimes been disappointed with
muted movements in $VIX futures
when $VIX makes a move.
To counter this, stay short-term
since $VIX is a 30-day measure.

“Term Structure” of Options

Actual Trading on 2/27/07 (mini-crash)
2/26/07 2/27/07 % change
$VIX 11.15 18.31 +64%
Mar VX Fut 11.44 14.81 +29%
Aug VX Fut 14.28 15.10 +6%
• So, even the near-term futures were disappointing.
• $VIX traders correctly anticipated that $VIX would
decline sharply, which it did within a week.

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.

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.

Term Structure Sept-Oct 2008

Term Structure After March ‘09 Low

Term Structure, Fall 2009

Recent Term Structure

$VIX Futures Predict Broad
Market Price Movements
In the previous slides, traders of $VIX futures
and options might have been frustrated because
the futures didn’t move the “full” amount, but
that’s because the futures had already
discounted the market move to come.

$VIX Futures As A
Technical Indicator
The front month* (nearest-term) VIX futures
sometimes 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

A series of $VIX Futures
premiums or discounts…
…is often a longer-term market signal
Discounts in a falling market are a
bullish setups
Premiums in a rising market are
bearish setups

$VIX Futures As A
Technical Indicator
Huge VIX futures premium in late December “foretold”

of stock market problems on the near-term horizon:
$SPX fell 230 points in less than a month
$SPX
vs.
$VIX
Futures
Premium

Actual vol vs. Implied vol (Futures)

Term Structure as Predictor
Spread between two front months
Spread between months 1 & 3
Shape of the term structure
It is the change of these items that is important

As the curve
moves from
positive slope to
flat to a negative
slope, $SPX
should be rising.

Trading The Term Structure
Trading 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)

More On Trading Term Structure
Extremely High Leverage
Risk Is Unlimited
(futures spread may “invert”)
May be better implemented with

ETN’s or Options

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 next
month’s $SPX option expiration
• To price them with a model, they must be
treated like futures options

$VIX Options
New Product: launched 2/24/06
Cash-Based options on $VIX
Are priced like futures options, however
Open interest is large: 2.19 million (11/20/2007)

$VIX Call Options – October 10, 2008
$VIX: 69.96
Oct Nov Dec
25 Strike Calls 31.60 13.70 10.00
Seemingly incongruous pricing, at face value.

$VIX Call Options – October 10, 2008
$VIX: 69.96
------------
Oct Nov Dec
25 Strike Calls 31.60 13.70 10.00
Futures 56.71 38.30 33.78
Ignore $VIX: the underlying for each option
is the corresponding futures contract.

Some $VIX Option Strategies
Behave Differently
Calendar Spreads
No longer have limited risk.
Option 9/10/08 10/10/08

Oct 25 call 1.75 31.60
Nov 25 call 2.15 13.70
Paid 0.40 for “calendar spread.”

Loss is -18.30 on 10/10/08!!

Hedged Strategies
Using $VIX Derivatives
Spread: SPY vs. $VIX options
Calendar spread using $VIX futures

A Hedged Strategy When $VIX
Futures Are “Out Of Line”
$VIX: 23.60 May VX futs: 26.10
Could try to short $SPX because of the premium on
the 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

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 discount
or premium on the $VIX futures
If discount: buy calls on both;
If premium: buy puts on both.
In essence, it’s a long straddle with an “edge” in
the $VIX options; with no “edge” you could buy
SPY straddles (or $VIX)

$VIX/SPY Profitability
If the Discount/Premium disappears, the spread
should profit.
1) If $VIX “moves” to the futures’ price, the SPY
side of the trade should profit
2) If the futures “move” to $VIX, the $VIX side of
the trade should profit.

How Much Discount/Premium?
“Traditionally” +/- 2.0 points or more
The bigger, the better…

Why Use Options, Not Futures?
Options give you 2 ways to profit:

1) Convergence
2) Large price movements
Example :next slide

Why Options? Example:
From the 17th to 29th Discount widened from -9.61 to -14.03,

But strategy made money because of volatile movement and
the fact that options were used
How Many Options To Buy?
General intermarket spread formula:
Ratio = (v1 x p1 x u1 x ∆1) / ( v2 x p2 x u2 x ∆2)
where v = underlying historic volatility

p = underlying price
u = units of trading (100 shares/ option)
∆ = option delta (if using options)

How Many Options? Example
If using slightly in-the-money options on each
side, the deltas will be roughly the same, so
formula simplifies to:
Ratio = (v1 x p1) / ( v2 x p2)

where v = underlying historic volatility
p = underlying price
Price 20-day HV
Oct VIX futs 34.0 82%
SPY 112.0 50%
Ratio = (34 x 82) / (112 x 50) = 0.50

So buy 2 $VIX calls vs. 1 SPY call
When to Exit or Adjust
1) If “convergence” occurs, then exit (i.e.,
$VIX and the futures trade at more or less
the same price)
2) If profits arise from movement, “re-center”
the 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 one
with new calls on both

Adjust: Examples
In The Option Strategist, on Oct 2nd 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

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

It Still Sets Up!
Thursday, April 15th:
$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
Calendar spread with limited risk:
Instead of :
Buy Nov 40 call, Sell Oct 40 call
or A Futures Calendar Spread

Instead of :
Rather, use LONG options on BOTH sides

Buy Nov 35 call, Buy Oct 45 put, for example

Instead of :
Rather, use LONG options on BOTH sides

Buy 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.”

Calendar Spread Alternative
9/10/08
$VIX 24.52
Nov 20 call 5.00

Oct 27.5 put 4.30
Combo: 9.30 DB to buy

9/10/08 10/10/08
$VIX 24.52 69.96
Nov 20 call 5.00 17.70

Oct 27.5 put 4.30 0.00
Combo: 9.30 DB to buy 17.70 CR to sell
Profit: 8.40

9/10/08 10/10/08
$VIX 24.52 69.96
Nov 20 call 5.00 17.70

Oct 27.5 put 4.30 0.00
Combo: 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)

Skew Strategies
Forward Skew:
Call Ratio Spread
Put BackSpread
Horizontal Skew:
Dangerous in $VIX options

$VIX Options Call Ratio Spread
Forward Skew Trade:
$VIX: 22
Buy April 25 call: 1.80
Sell April 27.5 call: 1.25
Sell April 32.5 call: 0.60
Total 0.50 credit
Upside Breakeven: 35.50
The Newest Volatility Product:
$VIX ETN’s
Two Barclay’s iPath ETN’s
VXX: $VIX Short-Term Futures Index
Blended average of front 2 $VIX futures months
VXZ: $VIX Mid-Term Futures Index

Blended 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: ETN’s
The
relationship
between the
two reflects
the general
term
structure of
$VIX futures

History of $VXO

$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”
According to a well-known study, a portfolio consisting
of 90% $SPX and 10% $VIX outperforms $SPX in both
up and down markets. Later studies suggest 20%.
So you only need to hedge 10%-20% of your portfolio’s
NAV, assuming it performs “in line” with the broad
market.
Buy slightly out of the money $VIX calls, one or two
months out, and keep rolling them.

The “10% Theory” of $VIX

How Many $VIX Calls To Buy?
• 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%)

The $VIX Collar
Buy $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 short

call which caps all profits.

The Future?
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): $EVZ
Next: $VIX on rates.
My prediction: eventually, most active stocks will each

have its own “$VIX” with listed options! So, e.g., you
can hedge the volatility of IBM directly.
Volatility Projection

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Using Volatility (Derivatives)

In Your Option Trading

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• When IV is low, options are cheap

• When IV rises, the option gets more expensive

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A spike peak in IV in such a situation

Mostly useful in the broad market indices ($SPX)

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WHEN IMPLIED VOLATILITY PEAKS

So either BUY THE UNDERLYING

Stop: a new high in IV

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

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Huge VIX futures premium in late December “foretold”

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

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May be better implemented with

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

Seemingly incongruous pricing, at face value.

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Option 9/10/08 10/10/08

Paid 0.40 for “calendar spread.”

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Spread: SPY vs. $VIX options

Calendar spread using $VIX futures

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