Stay Away From This Volatility Play

| June 26, 2012 | 0 Comments

With the S&P 500 whipsawing these days, you can’t turn on any TV business program without hearing about volatility.

 Anchors are talking about how it’s on the rise and next, how it’s falling.

They also relentlessly talk about how being long volatility is the ideal stock portfolio diversification and hedge. 

Many investors have been looking for hedging alternatives as we wrestle with our own economic worries, as well as those in Europe.

And most research has shown that the CBOE Volatility Index (VIX) would do the job handsomely.   It’s inversely correlated to the S&P 500 from which it is derived, usually rising sharply when the S&P 500 falls.

But the reality of late has been a different story, as the VIX ETFs have shown.

Put simply, there’s a problem with the VIX ETFs.

To start, the actual VIX is basically a statistic and a non-tradable asset.  It’s an index and trades only option contracts based on the day’s price and/or future price.

Now let’s discuss the VIX Short-Term Futures exchange-traded note (VXX).  You see, this ETF is strictly based off only VIX futures and not daily pricing.

Now, let’s look at a quick example…

The July VIX options are priced off the July VIX futures.

The premiums they carry are based solely off of the July futures.  With the VIX at 19.75 today, the July futures trade at 21.50 and the August futures at 23.35.

So, how is this different than the VIX exchange-traded products?

The VIX Short-Term Futures exchange-traded note (VXX) price is based off the performance of the next two future months.

Keep this in mind for a minute because this is an important point when trading these ETFs.

Here’s why…

Unlike the VIX, whose price is based on the current month’s volatility, the VXX is composed of the two nearest-month futures, as its name implies.

And this means…

As we went into last week with the news of the Greek election and the Fed meeting, volatility projections were relatively high even as the stock market rallied. It is not surprising that it reflected concern to go along with the optimism.

So, traders who purchased the VXX experienced a “rolling affect.”  In other words, at the end of every trading day, the VXX managers sold some of the July futures and bought some of the further dated ones.

This occurs day in and day out.

The result is that if the farther month options decrease in price, the ETF itself is not going to correlate to the S&P 500 like the actual VIX index.

For instance…

When the S&P 500 was at 1,342, down 2 points on the week, the VXX was down 10% at that time. And it further collapsed this Monday even as the S&P 500 dropped because the premium in those further out futures plummeted after the Greek election.

You can start to see the problems here, at least when the futures are in contango.  That’s what happens when the volatility of future months are priced higher than the current month. 

For what it’s worth…

I’m a volatility trader and a firm believer that long-volatility exposure executed properly is the best hedge.

Even though we’ve definitely had some unusual intraday volatility in the last week, at the end of the day, the volatility level has been pretty low.  

And unfortunately, investors tend to buy volatility when it’s already pricing in expected events and is “overpriced.”

Believe me, if this isn’t something you want to pay attention to, stay away from these trades.

Instead, buy put options on your individual positions.

Safe Trading,

Marcus Haberman

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Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.