Options Trading News

Long volatility is the ideal stock portfolio diversification--at least in theory. But the reality of late has been a different story, as the VIX exchange-traded funds and notes have shown.

Many people have been looking for hedging alternatives as we wrestle with our own economic worries, as well as those in Europe. Research has shown that the CBOE Volatility Index would do the job handsomely as it is inversely correlated to the S&P 500, from which it is derived, usually rising sharply when the SPX falls.

But the problem is that the VIX is basically a statistic and not tradable asset (though the CBOE may change that with the introduction of tradable SPX "variance strips"). Current tradable products are based off the VIX futures; unlike equity underlyings, each of these contracts is its own underlying.

So the July VIX options are priced off the July VIX futures. The futures price in much of the nature of the volatility index, such as reversion to the mean, so they tend to move less than the spot VIX.

Usually the futures also carry increasing premiums, as they do today. With the VIX at 17.91 at the time of this writing, the July futures traded at 21.50 and the August futures at 23.35. The November and December futures were both above 27.

This is all in remedial background for the VIX exchange-traded products and their relatively lousy performance recently. The iPath S&P 500 VIX Short-Term Futures (VXX) exchange-traded note is compsed of the two nearest-month futures, as its name implies. There is also a daily roll, so hypothetically they would sell some of the July futures for 21.50 and buy August for 23.35 at the end of the day.

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

When the S&P 500 was at 1342, down 2 points on the week, the VXX was down 10 percent in that time. It collapsed as the premium in those front futures plummeted after the Greek election, and the SPX was up less than 2 points. It plunged again yesterday after the Fed meeting.

We have definitely had some unusualy intraday volatility in the last week. But at the end of the day, the volatility level has been pretty low, as the 10-day historical volatility has fallen back below 14 percent (calculated on a close-to-close basis). Unfortunately, people tend to buy volatility when it is already pricing in expected events and is "overpriced."

The VXX therefore comprises the two futures that are already pricing in significant gains in the VIX, and they have a daily roll that eats into returns. The VIX itself is pricing in more volatility than we actually have.

You can start to see the problems here, at least when the futures are in contango: All of that changes when the VIX term structure shifts into backwardation. So if that isn't something you want to pay attention to, then stay away from these trades.

The VelocityShares Credit Suisse Daily 2x VIX Short-Term Futures Fund (TVIX) is even more problematic. Credit Suisse created waves when it suspended shares of the TVIX. It had built up a substantial premium to its Net Asset Value, and that premium came crashing down the day before CS announced that it would start issuing shares again.

Now the premium to NAV is building once again. Right now the TVIX trades at $6.08 with the NAV at $5.32. This means that traders apparently haven't learned their lesson and are still willing to pay up--even further--to get long volatility exposure.

I am a volatility trader and a firm believer that long-volatility exposure, executed properly, is the best hedge. But right now that exposure is best found in index or ETF puts or collars.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of June 21.)