Monday, October 26, 2009

Mail Time- VIX Options

I received a question in regard to VIX options I wanted to tackle for this week's Mail Time post.

Something in the VIX option chain puzzles me and I wonder if you have observed the same phenomenon. The front month puts have higher premiums than latter month puts at the same strike price. This implies negative time value, which doesn't seem to make sense to me. Would you have an alternative explanation?


The short answer is that VIX options don't price off of the spot or cash VIX that most traders are looking at. VIX options are based off of VIX futures.

Keep in mind when the VIX futures are in contango (upward sloping over time with the second month trading higher than front month), this creates a scenario where the same strike put for front month options can be more expensive than longer dated options. This can be true because the back month puts are actually further OTM. Thus, although later dated options have more time to expiration (leading most to believe they should be worth more), they're not usually worth as much as you would think.

Now, if VIX futures were trading at similar prices or in backwardation (downward sloping over time), then you'd see the VIX options chain looking more like a normal equity options chain, with longer dated options priced more expensive.

There are caveats aplenty when it comes to trading VIX products. To tell you the truth, I'm still becoming acquainted with their idiosyncrasies myself. One such caveat to consider is the fact that VIX futures don't always move in tandem with the cash VIX. Since there's not really anything that ties VIX futures to the VIX cash, they don't have to move in lock step and often wander apart. However, they do converge at expiration, so as I've mentioned in the past the discrepancy between front month futures and the VIX cash will begin to diminish as expiration approaches. Consider the following setup:

Cash VIX at 23, November VIX futures at 22.

Suppose you think the VIX is oversold in the short term and want to exploit the expected rise in price by selling the Nov 22.50 puts for $1 credit. Fortunately you're right on and the next day the VIX rises to 26. Naturally, you would expect that the 22.50 puts to drop in value, but...

Not so fast!

Though the spot VIX rose to 26, let's say the NOV futures remained at 22. Given that the futures didn't budge, you're 22.50 put is probably still worth about $1.

Why might the cash VIX rise, but November futures remain low? Since the VIX is a mean reverting animal, the futures are perpetually pricing in or discounting any reversion to the mean expected to take place between now and expiration. So the short term pop in the cash VIX may be treated as an anomaly that's expected to come back down towards 22 by Nov expiration.

Take a look at the following Puts Matrix, focusing on the 22.50 strike (click image to enlarge):

[Source: OptionsXpress]

Now, consider the following table:

As you can see, the 22.50 puts are all trading around the same price. Despite the February options having 5x as much time to expiration as the November options, they are still identical in price (roughly). This would certainly not be the case in a normal equity option chain. As mentioned, this can be attributed to the mean reversion discounted in the futures which places the Feb 22.50 puts twice as far OTM as the Nov 22.50 puts.

This should help in understanding why it's probably more beneficial to use front month options when selling puts or put spreads on the VIX vs. back month options.

For related post, check out:


Bill Luby said...

Nicely done!

Tyler Craig said...

Thanks Bill-

Your site helped a ton in gathering some info and hammering out the details. A label search of "vix options" made me feel like a kid in a candy store. You've done very well in linking the related posts together.

Bill Luby said...

I appreciate the feedback.

Frankly, I really have no idea how to best use the label feature. At first I was throwing every sort of label I could into a post, but as time wears on the the body of work grows, I find it much more appealing for the labels to help link back to only the best posts on the subject, not every post that is tangentially related.

Ultimately I guess it's a lot of guesswork, which is why I started implementing the "related posts" feature at the bottom of some posts to help breadcrumb my thinking. I'm glad to see you have adopted a similar tactic.



P.S. I miss that comic... :)


News to me.