Schaeffer's Trading Floor Blog

Learning from Past (VIX) Mistakes

Why absolute levels don't matter when trading volatility

by 2/20/2013 7:36 AM
Stocks quoted in this article:

After hitting "send" on yesterday's post, I realized I could make the points in an even simpler fashion.

1. You can't lock in the CBOE Market Volatility Index (VIX) in the 12s via purchases of any sort of VIX future or exchange-traded note (ETN). The simple fact is none of these have a price tag that low.

2. You can lock in a VIX priced in the 12s by purchasing actual SPDR S&P 500 Trust (SPY) or S&P 500 Index (SPX) options, but that requires you to dynamically hedge these positions in some fashion.

And it's an offshoot of #2 that highlights why -- in my mind -- attempting to bottom-tick VIX is a silly goal.

Consider a world of about a decade ago, before you could trade the VIX in any fashion. It simply indexed implied volatility of an SPX (okay, at the time it was OEX) option with 30 days until expiration. To "lock in" that implied volatility, you did, in fact, have to purchase actual index options. You really only had one goal in an options purchase. You wanted to buy it at an implied volatility that underpriced the volatility the SPX would realize from the date of purchase until the expiration of the option. In other words, you wanted to buy an option at a 12 volatility, and then have the index move at a pace higher than 12 volatility.

That didn't guarantee the trade "worked," as there were specifics involved about how SPX achieved that realized volatility, how aggressively or un-aggressively you hedged, etc. But by and large, if you bought an option that under-priced future volatility, it was a good thing, plain and simple.

Absolute values didn't matter though -- it was simply the relationship between implied volatility and realized volatility going forward. If you bought 12 vol and the SPX realized 6 vol, the trade likely didn't work. Say you bought straddles and planned to aggressively hedge against them via SPX futures trades. The market didn't fluctuate enough to let you make back your daily decay.

If you bought 24 vol, and SPX realized 36 vol, the trade likely won, as you had ample opportunity to trade and offset your daily decay.

And here's a dirty little secret. These rules still exist today. If you net-buy options, you still need to either trade well enough to offset your decay, or hope the underlying makes a large move. So all that matters is the relative price of options (the implied volatility) to the realized volatility of the underlying. Volatility is only "cheap" if the realized volatility going forward exceeds the current implied volatility, no matter the absolute levels.

Case in point? The highest implied volatility readings since 1987 took place in 2008. And it was often a good idea to net-own options, because no matter how high implied volatility got, realized volatility often went even higher. Conversely, the VIX trough from 2004 to early 2007 was a lousy time to net-own options, as realized volatility stayed pathetically low.

My point is that you should only buy "VIX" or simple index options if you believe realized volatility will tick higher soon. Don't buy it because VIX looks "cheap" on an absolute basis. Time is money, and in this case it's money lost.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.


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