Trading the VIX Spike Is Tough

04/30/2010 12:01 am EST

Focus: OPTIONS

Adam Warner

Author, Options Volatility Trading

The CBOE Volatility Index (VIX) was up 30.6% on Tuesday (April 27), the biggest one-day spike since October 2008.

This volatility spike has mixed implications for the market going forward. In general, it's bullish in the short term to see such a sudden burst of fear. But going further out in time—maybe a month or so—it does not bode well.

This kind of move in the VIX is a rare event. We have had only 16 moves of 25% or greater since 1990, according to Ryan Detrick of Schaeffer's. And it's only seen seven spikes above 30%, according to Bill Luby.

But, I would exert extreme caution reading too much into the history of this. It's an incredibly small sample size. And it would get smaller if we separated the volatility spikes into those during intermediate bear trends (like in 2008 and around 9/11) and those in intermediate bull trends (like Asian Contagion and now).

If anything, it's quite similar to the two- to three-day moonshot in the VIX in January, when Greece first came on our radar. Back then, we saw an ugly week or so, then a resumption of the uptrend in stocks and implosion in option volatility. We're later in the game, but I would not be shocked to see a rerun here. The VIX did drop 7.58% today, and the major indices were up.

VIX Options and Futures

We preach constantly about the flaws in "trading" VIX products, and ironically, a VIX explosion like this highlights all that we find wrong with them.

VIX futures all anticipated a lift in the VIX, and the greater the time to expiration, the greater the lift expectation. VIX calls also "predicted" the lift, as we saw some large prints in far-out-of-the-money (OTM) strikes recently, such as VIX May 40 calls (VIX   100519C00040000).

But here's problem number one: VIX futures have "predicted" a lift in the VIX pretty much since last June. They trade at a semi-permanent premium. And VIX calls have also "predicted" a lift, as the general order flow is almost always to the buy side. Ironically, there has been more interest in selling VIX calls and buying VIX puts in the last month or so—so perhaps that was the better tell.

Let's say you did get bullish on VIX, though. That brings up problem number two: It's tough to maximize your gains via VIX products.

The VIX rallied $5.35 on Tuesday, but unfortunately, you can't actually buy the VIX. May futures opened on Tuesday with a $1.30 premium to "cash," and closed with a big discount. Throw it all together and the May VIX futures lifted $2.30. Still a nice day, but you only captured 40% or so of the pop.

And that was by far the shining light. July futures rallied about 6% on the day, while August futures only about 4%.

Again, the reason is that futures already price in a VIX spike. They still do, though nothing close to what we saw recently. July's carried a $6 premium to the VIX as recently as last week, but it narrowed to $1 by Tuesday's close.

Going forward, it will likely get worse. Let's say there's another leg to this, and VIX spikes up to the high 20’s. Unless it sticks for some appreciable length of time, the July and August futures will barely follow, as they'll consider it a blip and price in a mean reversion, now to the downside.

By Adam Warner of DailyOptionsReport.com

Related Articles on OPTIONS