By Lawrence G. McMillan
This article was originally published in The Option Strategist Newsletter Volume 18, No. 15 on August 7, 2009.
It is generally accepted that volatility decreases in a bullish market phase and increases during a bearish one. Even on a daily basis, CBOE statistics show that 75% of the time, if $SPX moves one way, $VIX moves the other. When longer periods are considered, the percentage changes (see page two for exact statistics). Yet, recently $VIX has begun to increase even while $SPX is blowing out to the upside. This is unusual action, and we’ll try to examine it in this article.
Of course, the movements in $VIX are closely related to those of the $VIX futures as well, so those will be an important part of this discussion, too. Finally, we’ll also be drawing on the information presented in the feature article three issues ago (“Large Differences In Historical and Implied Volatility”).
We have been writing about these and related topics daily and weekly for quite a while now, but since the time frame that is critical to the entire volatility derivatives spectrum – the fall of this year – is fast approaching, we thought it would be helpful to combine everything in one place.
$VIX and $SPX movements
One fact that we often state, without actually confirming it, is that $VIX and $SPX move opposite to each other. So, to remedy that, we ran a study on our database, and this is what we found.
One Day Move: $VIX opposite to $SPX 78% of the time
We conducted this study over the past 4160 trading days (from 1/28/1993 through 7/31/2009), merely comparing change in $VIX with change in $SPX. If both were up or both were down on the same day, that was in the minority. What we found was that on 78% of the trading days, $VIX moved opposite to $SPX1. This is a bit higher than the general “75%” figure that is normally accepted, but they are close enough to conclude that the fact that they move opposite to each other on a daily basis is generally true. We have often heard it said that the frequency increases for longer periods of time. However, our studies do not concur. For example, in the 3-day study, we compared each index’s close with where it closed 3 days prior. If the two move opposite to each from close to close over that 3-day time frame, then it was considered an “opposite” move.
Length of Percent of Time Time $VIX opposite to $SPX 3 days 78% 5 days 76% 10 days 74% 20 days 74%
This seemed almost counter-intuitive to me, so I looked into the data more closely. Let’s consider the 20-day moves. You would think that, over a period of 20 trading days (which is nearly a calendar month), that any move in $SPX would certainly be coupled with a move by $VIX in the opposite direction. In fact, if there was a definitive move in $SPX that was always true. However, if $SPX was just meandering around, then so was $VIX – in which case the results seemed to border on random.
Consider the case of May 8 to June 19, 2007 – a period of 30 trading days. Of those 30 days, when comparing them with their predecessor of 20 days earlier, only eight times (out of 30) did $VIX move opposite to $SPX. What was happening at that time?
$SPX was very flat and non-volatile over that 30- day period. Twenty days prior it had been crawling slowly higher. Meanwhile, $VIX was doing about the same thing, first crawling slowly higher during April and then flattening out during May. The fact that $VIX was rising during May while $SPX was rising was likely due to the fact that $VIX had been so low for so long. But in February 2007 – when the U.S. markets suffered a severe but brief decline, as the Chinese market fell sharply – $VIX burst upward. After settling down from that burst, traders began to elevate $VIX steadily over the next few months, eventually leading to the bear market, which began with the subprime debt crisis in August of that year.
Furthermore, the fact that $SPX was trendless during May 2007 also contributed to the low “score” for the “opposite” indicator.
In any case, we can certainly feel comfortable saying that $VIX and $SPX move opposite to each other about 75% of the time, over time periods of 20 days or less.
Recently, there has been some discussion in option-oriented circles about $VIX rising (it’s up from 23 to over 26 since July 24th) at the same time that $SPX is rising. Yes, $SPX is slightly higher since July 24th as well. On a day-by-day basis, though, $VIX has moved with $SPX on three of the past eight days – not a lot, but enough to raise some eyebrows over the entire eight-day period.
Keep these statistics and data in mind as we discuss the strategies surrounding $VIX and SPY options.
The $VIX/SPY Hedged Strategy
We have discussed this so many times in the past that I will just briefly state it for completeness in this article, and to allow newer subscribers to catch up.
When there is a large (more than one point, say) differential between $VIX and its near-term futures price, we have found a hedged strategy to be feasible. Returns from this strategy have varied greatly, but overall it has certainly been quite profitable.
The strategy is simple:
a) if $VIX futures are at a large discount to $VIX, then buy calls on both $VIX and SPY
or b) if $VIX futures are at a large premium to $VIX, then buy puts on both $VIX and SPY.
Remember that $VIX options are based on the price of $VIX futures as their underlying, for that is key to the potential profitability of the strategy.
Eventually $VIX and the futures must converge in price by expiration day. The convergence usually takes place prior to expiration, and often it is $VIX that moves to the futures price that creates the convergence. If that happens, the $VIX side of the trade will not gain or lose much, for the futures are remaining relatively unchanged while $VIX moves to them. Movement in $VIX won’t affect $VIX option prices unless the futures also move.
Ironically, the price of $VIX itself is basically an irrelevant piece of information regarding the pricing of $VIX options.
However, movement in $VIX will likely affect the price of SPY options. According to the data previously presented, if $VIX moves higher, there is a 75% chance that SPY will move lower – and vice versa. So, if the strategy is established with $VIX futures at a premium, then puts are bought on both $VIX and SPY. If $VIX moves higher to meet the futures, SPY will likely move lower, thereby producing a profit on the SPY puts.
Sometimes, though (25% of the time, approximately), SPY won’t move, but since convergence must still occur, the $VIX futures will move to meet $VIX. In the case where $VIX futures started at a premium, and we buy puts on both $VIX and SPY, then the $VIX futures would decline to meet $VIX. The $VIX puts would profit, since their underlying (the futures) declined in price.
The opposite cases occur when $VIX futures are at a discount, and the strategy dictates buying calls on both $VIX and SPY.
There is one other advantage to the hedged position: if the markets become very volatile, convergence is not even needed in order to profit. For example, last fall (2008), the $VIX futures were at a discount, so we bought calls on $VIX and SPY. Then the markets collapsed and $VIX spiked upward. $VIX and its futures actually diverged, but it didn’t matter. The $VIX calls were profiting greatly, while the SPY calls could only lose their initial, fixed amount. Thus a profit was generated even though prices diverged.
Currently, September futures are at a substantial premium to $VIX – enough so that the hedged strategy in the form of buying puts on both should be employed (more about that later).
Actual Volatility
Three issues ago (Vol. 18, No. 12) we discussed the fact that actual volatility of $SPX was quite low, compared to $VIX – and then the $VIX futures were at an even higher level. Our conclusion was that when $VIX futures are trading at a level 10 points higher than the 20-day statistical volatility of $SPX, the market is about to make a substantial and/or volatile move. This last occurred in late June, and since then $SPX has blasted 80 to 100 points higher.
Currently, the 20-day historical volatility of $SPX has dropped to 16%! Other considerations aside, this is almost unbelievable. This latest bull run has been so uniform in its daily movements that actual volatility is dropping like a rock (for comparison, the 10-day historical is 14%; the 50-day historical is 21% and the 100-day historical is 28%). You may wonder why “traders” seem to be so complacent as to have forced volatility down to these levels. However, these figures have more to do with the way volatility is calculated than with trader’s perceptions of volatiliy.2
The September, October, and November futures are all trading at prices above 28, so the conditions of “volatility” (more than 10 points differential between the futures and 20-day historical) are still satisfied. Expect another large, volatile market move to begin soon.
Why The Large $VIX Futures Premium?
$VIX futures premiums have been unusually large since mid-June, and they reached highs of over 5.00 points last week, before $VIX rallied a bit. In the past, such large premiums have been predictors of a market decline, but this time that has not been the case (at least not yet, and with the momentum behind the current move, it’s hard to imagine it disintegrating anytime soon).
In thinking about these facts, it seems to me that in the past the futures premiums and discounts – especially the premiums – were the result of “smart money.” A small segment of astute traders were able to predict periods of high volatility when others were not necessarily expecting it. In those times, the outright purchase of SPY puts was a winning strategy.
However, at this time, it seems that the expectation of high volatility in September, October, and November, (and even out to December), is a consensus opinion. Everyone is afraid of what the market might do in the fall and are loading up on puts as a result. That doesn’t seem like smart money at all, but more like an opinion that contrarians should “fade.”
This, in our opinion, is an even more convincing reason why the hedged strategy is preferable to an outright stance of buying SPY puts.
Summary
So that pretty much sums up the whole volatility picture at this time. $VIX futures prices are pumped up because a lot of traders expect the October-November period to be volatile. However, actual market movements have ignored this potential problem, pushing volatility lower during this bullish phase. The market is likely ready to make another volatile move, but the direction is unknown. So the $VIX/SPY hedged put strategy is the preferred one at this time, for it can profit from a volatile move in either direction, plus it has the “edge” of expensive $VIX futures to begin with. See page 12 for recommendation.
This article was originally published in The Option Strategist Newsletter Volume 18, No. 15 on August 7, 2009.
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