The Search for the Holy Grail of Volatility Trading
Options expert Lawrence McMillan, of McMillan Analysis Corporation, outlines how volatility trading is subjective and highlights the number of products that have been rolled out over the years in various efforts to track the volatility index.
Depending on your viewpoint, the holy grail of volatility trading can take on a different meanings. To traders, it’s a product that tracks VIX closely, if not exactly. To exchanges and market makers, it’s a liquid product that draws a lot of trading interest.
To that end, a number of products have been rolled out over the years. None has matched the VIX options and futures in trading volume and they have been the basis for nearly every other product: VXX, in particular (the Barclay’s Volatility ETN).
As we have pointed out in various recent articles, there are problems with most of these as far as tracking VIX goes. VXX, for example, has lost 99.7% of its value since inception in January, 2009. It keeps reverse splitting, else it would be trading for pennies. But it only mirrors VIX (and even outperforms VIX), when the term structure of the VIX futures inverts and slopes downward. In particular, that is when the front month VIX future (July futures, currently) trades at a higher than the second month VIX future (August, currently). That inversion in the front two months is rare and generally only occurs during fairly steep corrections or bear markets, both of which have been rare commodities for years.
We recently wrote about the new ETFs—VXUP and VXDN—designed to track VIX daily. It’s really too soon to judge how these are going to do in that regard, but from May 19 to June 15, VIX rose from 12.85 to 15.39, a gain of 19.8%. VXUP rose only 2.9% over the same time period. That’s because it was so overpriced on May 19, trading at a 13% premium to Net Asset Value (NAV).
As we’ve often pointed out, the best way to simulate VIX—not duplicate it (because it can’t be duplicated)—is to take a short-term position in the VIX futures and roll them over.