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January 21, 2013  Mon 10:05 AM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
In the last month we have seen a couple of interesting trends, both involving volatility trading. The CBOE Volatility Index itself has been highly volatile, and the volume in the VIX futures has seen record numbers, but volatility trading in equity options has been almost non-existent.

Trading volatility can be done in a number of ways these days. Retail traders can play the iPath S&P 500 VIX Short-Term Futures ETN (VXX), the VelocityShares Daily 2x VIX Short-Term Note (TVIX), the ProShares Trust Ultra VIX Short-Term Futures Fund (UVXY), and a host of other exchange-traded funds and notes. But these products have significant structural complications, which we have detailed elsewhere.

Despite those issues, volume has been setting new records in some of those funds, as it has for the underlying VIX futures. Those futures saw their highest two-day volume on Monday and yesterday as more than 220,000 contracts traded each day, building on the record weeks from the end of last year.

The VIX options are based on those futures but are the most complicated options available, as they are priced on underlyings that are derivatives of derivatives of derivatives. And each month is its own underlying asset, unlike any other equity option.

Before VIX futures were created, traders used delta-neutral option positions in indexes, ETFs, and individual stocks to get long or short volatility. One relatively simple way to get long volatility is to buy puts and then buy stock. If the puts you were buying had a delta of -0.5 and you bought 100 of them, you would have a delta of -5,000, so buying 5,000 shares of the stock would make the position neutral.

We normally see quite a bit of such trading, but not recently. It could be that such trading has migrated more fully over to the VIX market. However, delta-hedged volatility trading in equities provides a very different vehicle and can even be traded against VIX products, so that doesn't seem to make sense. It appears more likely that fiscal-cliff fears had a lot of volatility traders on the sidelines.

Going into the last weeks of the year the VIX seemed quite low, but it was much higher than actual volatility. Hedgers are more sensitive to what they perceive as possible future volatility and less sensitive to cost. That perspective, combined with the liquid nature of the VIX futures and options, may be what drove those record volumes.

But those who trade volatility through delta-hedged positions usually care more about prices. As such, they were probably hesitant to pay a large premium of implied volatility (cost of the options) over the historical volatility.

And while they would normally look to sell volatility in such times, the potential volatility pop with the fiscal cliff was significant, so they were on the sidelines as well. It will be interesting to see if and when they come back into the market, or if we are seeing a further shift of the dynamics of this type of trading.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Jan. 3.)
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