Trading Volatility? Try This…

06/14/2010 11:02 am EST


Adam Warner

Author, Options Volatility Trading

In the never-ending quest to give you new ways to trade volatility, I bring you options on the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). (Well, I don't bring you them personally, the exchanges did, but I can help navigate.) As we noted last week, VXX and VXZ are exchange traded notes (ETNs) based on CBOE Volatility Index (VIX) futures.

VXX is the far more popular of the two, as it proxies a perpetual 30-day VIX future. VXZ proxies a daily rolling long position in the fourth-, fifth-, sixth- and seventh-month VIX futures contracts.

In order to maintain the proper duration, each of the ETNs must roll out futures from near to far every day. The VIX virtually always trades in contango, that is, the further from expiration, the higher the future price. That has scant impact on VXZ as there's generally little difference between fourth-month and seventh-month VIX futures. But it can wreak havoc on VXX, as we've seen differences as high as six volatility points between front month and second month.

It's flat now, but if the VIX declines, the curve will steepen again and VXX will get the double whammy of declining VIX and a money-losing roll trade every day. In fact, that's what happened for the first 15 months or so of VXX existence, when the ETN lost more than 80% of its value.

How bad is that? Well, VXX tends to track about 50% of the VIX's daily move, and VIX "only" lost about two thirds of its value. But we're not here to talk about the past, though it's important to note what can happen.

We now have options on VXX and VXZ, which just listed within the last couple of weeks, and I find both superior to VIX options. Why? Well, for starters, VIX options give you delivery of nothing. They cash settle on expiration day and officially leave your sheets forever. VXX options deliver (or get delivery of) VXX stock. The same goes for VXZ. You can also exercise them early (and get assigned), whereas VIX options are European exercise.

What's more, the clock never strikes midnight on VXX. It always tracks a hypothetical one-month future, and thus, always has the same basic properties. A VIX option, on the other hand, tracks a normal future, one that behaves very, very differently depending on time remaining until expiration.

Consider a September VIX future. It has three months remaining until expiration, and will correlate relatively lightly with VIX moves. But in a month, it will track much closer, while a month after that, it will mirror almost every move in VIX.

A VXX September call, however, will price off VXX, which prices a perpetual 30-day future now, a month from now, and two months from now. It will have some consistency of behavior, and I find that much easier to manage.

VXX isn't perfect by any stretch, and there's a good chance it declines over the course of time, but on a day-to-day basis, it's reasonable to expect it to capture about 50% of the VIX move. I would say that basically any option strategy that suits you can work in here.

VXZ is a very different animal. It's just not going to capture much of any VIX move. A regular future four to seven months out obviously gets closer as time goes on, but VXZ stays out there on the curve. And out that far, you just don't see much movement. The further you go out in time, the more the contract assumes any VIX move is a short-term blip that will mean revert. So you don't really accomplish much owning VXZ. It won't hedge a portfolio well at all. It also won't decline that much if VIX dips, but that begs the question of why to bother with it to begin with?

If I traded VXZ options, I would want to short strangles and manage it around the occasional blip. One problem though: The early options quotes are wide and illiquid, so not worth putting on a position just yet, as it's not worth the inevitably poor order fills.

By Adam Warner of

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