Even if that argument doesn’t convince, he does mention an interesting trade, which is to buy September 30 or 32.50 VIX (Chicago Board Options Exchange volatility index) puts and hedge with at the money SPY (ETF that tracks the S&P 500, whose implied volatility is measured by VIX) puts. What happens is, if the VIX drops as the market rises, the VIX puts make money, but the SPY puts lose value. If the market drops, the SPY puts increase in value, but the VIX puts lose value.

Now the question is, how much of each to buy?

Vega

What we have to look at is, for a move of, say, ten points down in the S&P 500 (which is equal to one point in the SPY) which would make our SPY puts more valuable, how much would VIX drop, which would make the VIX puts less valuable?

How much would the value of the SPY puts increase for a 1 point drop in SPY? Since their delta is near -0.5, they would increase in value by half a dollar.

That is one piece we need.

We need to figure out how much the VIX puts drop in value when SPY drops. To do that we use the SPY vega. Vega of SPY is 0.12 so the change in the implied volatility of SPY would be given by the change in the SPY option value divided by the option’s vega, or 0.5 / 0.12 or 4% for a 1 point drop in SPY. But this is 4% of the implied volatility. Since the implied volatility is 27, this gives a change of the implied volatility of 4% of 27 which is about 1. So the implied volatility would go from 27 to 28.

This change is the underlying that moves the VIX puts. So since the VIX 30 puts have a delta of -0.7, that would change the value of the VIX puts by (-0.7) * (1) = -0.7

So it is these two changes in value that we want to hedge. It looks like we would need about 7 SPY puts for every 5 VIX puts (7 SPY * 0.5 + 5 VIX * (-0.7) = 0).

Where Does The Profit Come From?

One way to figure that out is to look at the vega of the SPY puts and compare it to the delta of the VIX puts. That way, we are looking at the change in the value of the SPY puts when their implied volatility changes (that is what vega measures), and comparing that to the change in the VIX puts when its underlying (the implied volatility of the SPX index) changes.

The vega is the change in the value of the option for a small change in the implied volatility. For the 99 or the 98 SPY put, vega is $0.12 and the delta of the September 30 VIX put is -$0.71. For the September 32.50 VIX put the delta is -$0.89. So we would have to buy six times as many SPY puts as VIX puts. That would make us immune to movements in the implied volatility.

If we bought 7 SPY for every 5 VIX, we would profit from the change in implied volatility calculated above. The VIX puts are six times as sensitive to changes in implied volatility of the SPX as the SPY puts are. If the S&P implied volatility drops, the vega measures the change for the SPY while it is delta that changes the value of the VIX puts.

What has AAPL done recently when earnings are announced? Here is the move from the close before earnings to the open the next day.

The average move is 2.39%, but there are a lot of large moves. There are three times when the close to open move is less than 1.5%, one -3%, six times around 6%, once an 8% move, once greater than 12%, and two moves down greater than 10%.

To try to center the returns around 140 and 165, we can try a dual calendar spread, selling the 140 Aug put and buying the 140 Sep put and selling the 165 Aug call and buying the 165 Sep call. Here is what the return looks like. The dark line is expiration, which we aren’t waiting for, so lets look at the blue and red lines.

If the August options’ implied volatility drops to the Sep values, this is what tomorrow’s return looks like:

So a big part of the return is the drop in volatility. Apple August options volatility should drop to the out month value once the uncertainty of the earnings are digested.

Google Dual Calendar Spread

The July options’ implied volatility is much higher than August. After earnings the implied volatility of the near month collapses. What effect does that have on the profit graph?

Here is the profit graph of the dual calendar spread with the volatility skew.
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This is what happens if the volatility of the near month options drops to the implied volatility of the far month options.

The intermediate profit rises to the final form when the near month volatility drops. So you get an added lift from the implied volatility collapes.

Here is the chart from his post:

SPX on top, VIX in the middle, and CSFB skew index bottom

Adam Warner doesn’t see that the CSFB skew index adds much value.   He points out the huge dip in CSFB last October when VIX was hitting the 80s.  That has put many people off this index, why would there be a dip there?

CSFB tells you what your deductible would be on the put side if you were paying for it with a 10% out of the money call three months out.  What that means is, find the price of the call three months from now that is 10 % above the market.  Then look for the put three months out that sells for the same amount.  How far is that below the market?  That is CSFB for today.

To put on a zero- cost collar with options that expire in three months, sell the 990 call (SPX at 900) and that will finance  the put 19% below, at 729.  This is about 2/3rds of the max skew that CSFB has seen.

So last October, all the puts had high vol so the skew was low.   Counterintuitve, but possible.

One detail straight off is that the comparison should be with the VXV not VIX since VXV and the skew index measure three months out. Here is what VXV looks like:

S&P 500 Options Volatility Three Months Out

Not very different than VIX, a little higher, but still at a low point of the last six months.

So what doesn’t move volatility? An low delta OTM call spread in a VIX product to name one thing.

What actually does? Well, stuff like this, from OptionsMonster last Friday (free sub. required).

If you’ve ever wondered where volatility goes to die, read on.

Two recent trades made bear important lessons on why the VIX is near its lowest levels in nine months.

In the largest of these transactions, 200,000 calls and puts on the iShares Silver ETF were sold, and only 75,000 calls were bought. It followed a similar trade on the SPDR Gold Shares exchange traded fund, where 33,000 options were dumped on the market while only 16,500 were taken back out in the form of purchases.

These kinds of trades set off a chain reaction that helps explain why the VIX has plunged in recent weeks. The volatility index is at its lowest levels since September.

As trades like this become more common, they are bringing volatility down. And as volatility subsides, traders bring in less premium selling out-of-the money options. They respond by selling even more options, which then depresses volatility everywhere. We noticed traders using this tactic with Gap options as well, selling twice as many GPS contracts as they bought. Since then the strategy has also been used on McKesson and Baxter International contracts as well.

I’d replace “strategy” with “order flow” above, as it’s not necessarily the same players buying and selling. But the point is spot on. As more call sellers come in, it sets off a daisy chain of bad news for volatility.

Market makers buy all the calls for sale and now find themselves long gamma. They react by lowering options bids across the boards, and attempting to make back some options decay in the stock via shorting into strength and buying into weakness. On the margins both the lower options volatility and increased liquidity in the stock serve to pressure realized volatility down. Which in turn may translate into even more interest in shorting options ever cheaper.

Rinse and repeat.

Index volatility depends partly on the volatility of the component stocks themselves. So as that decreases, it necessarily decreases index volatility.

And this is indeed much of what we’ve seen. At least until Monday as the VIX has turned up a bit.

Jared at Condor Options provides a Volatility Tracker of all sorts of instruments each week. Yesterday, he noted this.

This week’s report is a little late, but after the close Monday I see little reason to change any of the comments below. The Dow Jones Industrials closed down 187 points, but that’s not so remarkable when you consider that, on Friday, the Dow volatility index (VXD) implied a standard deviation of daily moves of 140 points.

I popped a similar observation on twitter yesterday in regards to the SPX.

Basically, we have gotten so used to lack of stock volatility that a rather unexceptional drop like yesterday almost felt like a crash. But implied volatility levels already assume moves of this magnitude should be more common.

You can take any volatility level and covert it to (sort of) an expected range for the underlying. Just divide it by the Square Root of 252 (the number of trading days per year). That number equals 15.86. So divide the VIX, now in the low 30’s, by that and you see an expectation of a 2% move per day or so.

Except that’s not exactly what it says. Actually, it says that 68% of days should see a move of under 2%, and 32% should see greater than 2%. So by that metric, yesterday’s move down in SPX was pretty………normal. If we start seeing that every day though, clearly options volatility will perk up. But the larger point remains that Implied volatility already prices in a little pickup in the fluctuations.

If I had to lay out a scenario here, it’s that we see a brief bout of volatility this week before resuming out inexorable march towards inaction again after Expiration. I am going to use this week to sell July volatility (probably puts) while defending it with some leveraged ETF’s.

OK, apparently caused lots of dissenting opinion in regards to slapping on a spread that involved going long VXX and short SPY near term options.

So let me clarify a few points.

This is just a convoluted way around a relatively simple trade, an SPX or SPY calender. So what if we forget VXX and VIX futures exist. The basic thought here is

when volatility caves, I generally would prefer owning calenders. That involves buying longer dated options at likely a higher volatility than I am selling the shorter term options. It gets me short gamma and earns money in the form of time decay.

You have to look at this as two separate transactions though. The short side of the options will earn me money if the realized volatility between now and expiration is less than the volatility I sold them for. Yes, part of that trade likely involves chasing stock into strength and shorting it into weakness. The idea is to lose less doing that than you earn in options attrition.

The long side of the calender is more of a bet on implied volatility at least holding steady. You will not lose all that much time decay, but you are at risk of a move lower in volatility. But if you think options volatility is a buy longer term, you are OK with that.

So combine the two and you are effectively betting on longer term implied volatility to outperform shorter term realized volatility. If you think that’s a good bet, a calendar makes sense.

Using VXX or a VIX future in lieu of a longer dated SPX or SPY option is not identical, but you will win or lose with it in a similar pattern as above.

But it’s important to remember however you chose to go long a longer dated option, it’s not a big deal if you “buy” higher volatility than you sell. It’s two different time frames and two very different bets, there’s no reason they will or should carry the same volatility. A few weeks ago they all did carry about the same volatility. That’s more unusual than not.

So what’s the risk in buying a calendar, or buying VXX and shorting SPY options?

It’s not that some small volatility difference between the two cycles will revert to 0. There are 2 big risks however. One is that realized volatility, which you are effectively shorting, will explode and longer term volatility will not lift as much. You would have got hit massively with that last Fall. Which is why I don’t like this position in a rising volatility environment.

The other risk is that all volatility caves in. Your short volatility will only earn you so much, I mean your options can only go to zero and you will get lousy prices trying to roll them. Meanwhile your VXX or VIX future or longer dated SPY straddle has gotten mauled.

Post getting long here. To be Continued.

Here’s a take on today’s VIX move that’s so useless it almost had to come right off the CNBC website.

The stock market’s main fear gauge moved past a key level on Monday, indicating possible troubles ahead for the market.

And one options player with deep pockets is making a big bet that volatility will increase sharply, making this a tumultuous summer.

The Chicago Board Options Exchange Volatility Index, or VIX, moved past 30, a mark it hasn’t closed above since June 4. A VIX reading of better than 30 generally indicates high volatility that usually accompanies stock market drops.

Following suit, stocks lost more than 1 percent.

Oh, where to begin.

There’s nothing “magical” about VIX 30. The move from, say, 29.75 to 30.25 bears no more signficance than say, the move from 30.25 to 30.75. In fact, the VIX is a contrary indicator. Higher levels indicate more fear, on a contrarian basis is actually bullish.

And it’s completely absurd to define today’s action as the VIX lifting and stocks “following suit”. Aside from the obvious fact that stocks were down 1% before the options marts even opened, it’s akin to the logic that umbrellas cause rain.

So what was this big trade? We mentioned it earlier, but here’s some more color.

The joint moves in the VIX and stocks come just a few days after a big investor bet on the VIX caused tremors in the options market.

One trader on Thursday bought 20,000 July VIX calls at the 45 strike and sold 55 strike calls for an overall premium of 42.5 cents in a trade that cost about $850,000 to execute. The net impact is that the VIX would have to beat the 45.42 level by the July expiration for the investor to make money. The VIX hasn’t been past 40 since April 21.

“The last few weeks we’ve come under 30 and we’ve been under 30 as investors became more sanguine in their approach,” said Andrew Wilkinson, senior strategist at Interactive Brokers. “This was a standout trade that went against the grain.”

While there would be no direct correlation between such a huge trade and the actual VIX movement, the bet could be indicative of a shifting mood.

Let me get this straight, for $850,000 of cheap VIX spread caused tremors in the options marts? The spread has a delta of about 8 now, after the lift. Meaning someone hedging the other side only has to buy about 1 VIX future for every 12 spreads he does. Which would have modest upside impact on the future, but really not cosmic. Especially since as a vertical, it’s defined risk, and will likely be underhedged.

Could this be indicative of a shifting mood?

It could. It could also someone hedging a portfolio that has had a nice run. It could be someone taking a cheap VIX shot. It could be a desk with Variance risk just closing something off. It could be Lenny doubling down.

What it can’t be is all that meaningful. There are countless trades of this size each and every day all across the floors. If someone can move entire markets by purchasing $850,000 cheap OTM VIX spreads, we have bigger issues to deal with than we realize.

From The Daily Options Report by Adam Warner on the seasonal cycle of volatility.  It bottoms end of June beginning of July, then picks up in the summer for a peak in the fall.

For all the talk about “bottoming” the VIX, I would like to throw one little splash of cold water on it.

As per numbers I ran for my book, Options Volatility Trading: Strategies for Profiting from Market Swings(Amazon link) July cycle shows the lowest mean and median VIX readings. Early in the July cycle, really from June expiration into July 4th or so, is particularly bad, and in fact often is the low water mark of the year.

So with “cheap” options volatility already overpriced relative to realized volatility, and the last week of a cycle not a good time to buy options of the following cycle under any circumstance, I’d really refrain from “bottom fishing” July paper here. It will likely get cheaper in volatility terms.

Now none of this says anything about actual stock volatility this coming week. It’s expiration, anything can happen. I tend to think that if it’s non-volatile heading into expiration week, it stays that way. But you always have the chance of an event getting some names on the move. What it does say though is not to let a potential active day or two seduce you into buying July options. Treat it as a blip in volatility, not the start of a new trend up.

And none of this says anything about VIX futures, or VXX. Remember the VIX future just looks at a snapshot VIX reading for the day it expires. The pattern is ugly volatility early in the July cycle, but the VIX may very well rebound by the end of the cycle. Expect VIX July futures to keep a healthy premium to “cash”.

Jamie here notes something interesting. June volatility is about 15 points higher than it was in May at about this juncture in the expiration cycle.

Well it was 15 points higher. Jamie also notes some sellers in the June calls knocking it down a bit to about 10 points higher.

But let me just clarify something first, since this is the most difficult product to explain, ever. Jamie is referring to volatility OF the VIX options, not VIX itself. In other words an ATM option on the VIX, call it the June 30’s, is trading 15 volatility points higher than a comparable May VIX option was trading with 2 weeks or so to go until expiration.

Got that?

The VIX measures volatility expectations for the SPX. VIX options measure volatility expectations of that volatiltiy expectation. So it’s a bit rough to analyze what exactly that means.

I missed it when I was watching the video.

What does it mean? An increased uncertainty about how much SPX could move around. Take it to the extremes and see what it means. If the vol of the VIX were zero, the market knows exactly how much SPX will move around in the next month. If VIX vol were 100% the market is biting its nails expecting big changes in how much the SPX moves.