ZeroHedge in his never ending quest to prove the market will go lower posted that the VIX:VXV ratio has hit a 2009 low. And he’s correct, it has hit a low.

To refresh, VXV is the same as VIX, but for 90 day options. So it’s a look at longer term volatility assumptions. The thinking is that if the ratio gets out of whack, the VIX will “revert” to the VXV. Thus when the ratio is low, the VIX should revert up.

And it should, but I would suggest that all that means right now is that near term options are pricing in a very slow stretch the next couple weeks. It has very little predictive value right now as to where the market will go next.

Check out the top graph, the VIX:VXV ratio for as long as they have quantified the VXV. Notice something about every trough? It’s almost always a slow pre-holiday stretch.

Check out the last week of 2007, Memorial Day and Labor Day 2008, end of year 2008, et. al. It correlates better to that than actual market moves (chart below is SPY over the same time frame. Notice also a disastrously bad “high” ratio signal last September/October. Turns here have great predictive value if you are in the dark about our federal holiday schedule. Not so much for the SPX.

I’m not saying there’s no utility watching this relationship. Volatility after all is mean reverting. You just have to keep in mind that often “mean revert” is nothing more than a “calender revert”. And I would suggest that’s exactly what we are seeing right now, a window of time that is the single worst stretch for the VIX itself.

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.