Saturday, August 6, 2011

Volatility Trading Myths!

The VIX volatility index is supposed to be a proxy for volatility. However, when it comes to the VIX, nothing trades quite like you think it should. 

Don’t Believe All the So-Called VIX Experts. According to an article by Adam Warner in Investor’s Place - "Ten years ago, most people hadn’t even heard of the CBOE Volatility Index, or VIX. These days, the “fear index” is covered by the mainstream financial media, and you can’t throw a stick without hitting someone who fancies themselves a VIX expert."

The problem is that half of these people don’t have any clue what they’re talking about. So there is a lot of misinformation out there surrounding the VIX and VIX trading products, including futures and ETNs. When it comes to trading the VIX, nothing moves quite like you think it should.

To clear things up a bit, here are eight VIX trading myths you don’t want to fall for.

VIX Myth #1 – You Can Buy and Sell the VIX

Reality: You cannot buy and sell the actual VIX. You can buy and sell VIX futures, but that is a very different thing. VIX futures can trade at premiums or discounts to the VIX. In fact, they almost always trade at premiums to the VIX.

VIX Myth #2 – You Can Own the VIX Via Futures

Reality: VIX futures cash out when they expire based on a VIX settlement price. So unless you roll out, your position will vanish.

VIX Myth #3 – A Rolled Position Will Track VIX Moves

Reality: VIX futures price based on where the market expects to see the VIX on a given date in the future, i.e, the day the VIX expires. That estimate may or may not move on a given day with a move in the VIX. The further out in time the future is, the less it will track VIX moves.

VIX Myth #4 – VXX Tracks the VIX Better Than Futures

Reality: The iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX) is an exchange-traded note that is based on a hypothetical rolling 30-day VIX future and trades like a regular stock. However, it does not track VIX moves particularly well. In fact, it underperforms over time so long as VIX futures trade in an upwardly sloped term structure. And VIX futures virtually always trade that way.

VIX Myth #5 – You Can Chart VXX Like a Stock

Reality: Since VXX trades like a stock, you may think you can chart it like a stock. Wrong. Run, don’t walk, from anyone who tells you about a key chart point on VXX. The VIX is a statistic, and VIX futures trade based on estimates on a forward price for that statistic. VXX creates a hypothetical constant duration 30-day VIX future and, therefore, loses money each day simply rolling from the nearest month future to the next month out if the next month out trades at a premium. Hence VXX is really just a number relative to itself the day before. It’s the tail of a tail of a tail of a dog.

VIX Myth #6 – Holding VXX Can Protect a Portfolio

Reality: VXX works fine as a short-term trading vehicle. On a day-to-day basis, it will track about 50% of the VIX move. However, it is terrible as a portfolio hedge for the reasons listed before, namely that it loses money over time in an upward sloping VIX term structure. Owning and rolling two- to three-month VIX futures works better.

VIX Myth #7 – VXZ is a Good Portfolio Hedge

Reality: The iPath S&P 500 VIX Mid-Term Futures ETN (NYSE:VXZ) is similar to VXX, but it tracks four- to seven-month VIX futures instead of 30-day VIX futures. VXZ has done relatively well since its inception and has outperformed VXX by a wide margin. But while it doesn’t have the contango trouble of VXX, the VIX curve gets pretty flat out that far. I would also caution that VXX and VXZ only listed in January 2009, and thus, neither has had to show its mettle through a VIX storm. Four- to seven-month VIX futures almost always hold their premium to the VIX, but would move to a significant discount in a serious VIX explosion. In 2008, they lagged by 20-30 points. So I suspect VXZ would not provide great protection when you wanted it most. It’s a fine volatility proxy in a quiet market, but if the goal is insurance, it may disappoint.

VIX Myth #8 – High VIX, VIX Call Buying is a Signal to Get Out or Get Short

Reality: I don’t agree with the above, but I can’t actually prove it wrong. I will say this though, the VIX is a mean-reverting statistic. A high VIX and excessive VIX call buying (and actual SPX put buying) represent extreme nervousness and/or bearish sentiment. In theory, that’s a time you want to buy, not sell. But take that with a grain of salt, because trends do take on a life of their own, like the VIX explosion and market implosion of 2008.

If you really want to trade volatility you’ve got  to trade VIX products. Email me for details.