Tuesday, February 26, 2008

Do Reliable Oscillations In The VIX Make VIX Options An Easy Profit Vehicle?

I’ve seen some articles in the press over the last few months suggesting that one way to profit in volatile markets is by trading VIX options. They typically make it sound easy. “You don’t even need to know the direction of the market. You just need to determine whether volatility is likely to rise or fall. If you think volatility is going higher, you can buy VIX call options. If you think its going lower you can buy VIX put options.” The problem with this logic is that VIX option prices do not follow the VIX index. They follow VIX futures prices. A couple of months ago I decided to quantify how much this really matters.

It is well known by traders that the VIX has a strong tendency to oscillate. Therefore, when people consider trading the VIX, they many times think mean-reverting strategies will work best. I took some simple mean-reverting strategies and applied them to the index to see what kind of returns I would get. Two examples were: 1) Short the VIX if it closes 15% or more above its 10-day moving average. Cover when it closes below its 10-day moving average. 2) Short the VIX if it closes at a 10-day high. Cover when it closes below its 10-day moving average. In both cases the opposite stretch would apply for purchases. Not surprisingly, they worked. What was intriguing was HOW WELL they worked. I then combined these strategies with a few others to create an indicator which would signal to me when the VIX was stretched and due for a reversal.

Assuming you treated the VIX as a security and allocated a certain dollar amount whenever you bought/shorted it, over the last 3 years my simple system would have returned about 170% per year based on raw returns (no commissions or slippage).

Now, to see the effect that trading futures would have on the system, I downloaded all the historical data from CBOE and ran the trades through using front month options. I performed rollovers those times when the future expired before the trade closed. Note that the entry and exit triggers were based on the action in the VIX – not in the futures. The purpose of the study was to see whether someone could trade futures/options based on the action in the VIX index. The results? Instead of returning 170%/yr over the last 3 years, the system now returned 5% total!! Factor in some commissions and slippage and my incredible system is now a money-loser.

Moral of the story: Be careful when trading VIX options / futures. Simple systems which look spectacular on the VIX cash index simply do not translate.

Below are some informative links which also discuss this issue.




Alex said...

Are there alternative methods for trading the VIX, i.e, using S&P index options to create a delta-neutral, positive/negative vega position? What about using the notion that VIX futures successfuly predict future VIX movements to find opportunities to buy or sell vega?

Anonymous said...

Instead of trading VIX options, why not using VIX mean-reverting strategies on an index, say S&P 500? Will it work as well as if applied directly to the VIX itself?

Alex said...

I've also considered a strategy that incorporates the inverse correlation between the VIX and S&P 500. When VIX is high, we expect VIX to fall and S&P to rise - sell puts. When VIX is low, we expect VIX to rise and S&P to fall - buy puts. This strategy may provide a good hedge to market shocks.

Rob Hanna said...

I think the VIX is an excellent indicator and have used it to successfully time market entries for a long time. I have done only a small ammount of trading in VIX options. As this post suggested it can be tricky so I generally stay away.

The ideas mentioned to use the VIX as a way to time the S&P are spot on. Alex's idea of buying and selling S&P puts is a good one.

I'll write more on S&P timing using the VIX in future posts.

Two blogs that offer excellent VIX coverage with some good discussion of more complex strategies are VIX AND MORE and the Daily Options Report - both are in my blogroll. Larry Connors at TradingMarkets.com has also published a lot of good work on this subject.


Bill Luby said...

Superb analysis, Rob -- and thanks for the mention.

Your blog is already one of a kind.



Anonymous said...


for what reason should one prefer VIX options over using VIX futures (front month) in order to try to match VIX movements ? VIX options are derivatives on derivatives (VIX futures), which are derivatives
on a statistic figure (VIX) based on the implied volatility of a couple of S&P options, the latter ones themself derivatives on an index.

VIX front month futures do usually have a correlation between 0.8 and 0.95 (PEARSON) versus the VIX (depending on the time frame and the current value of the VIX) and
would therefore much better match the movement of the VIX than VIX options.

Concerning your VIX trading system No. 1) and if one would have used VIX front month futures instead of VIX options, trading results would have been much different (in a positive manner):

1) Short the VIX front month future (1 contract) on every trading day when the VIX closes 15% or more above its 10-day moving average. Cover when it closes below its 10-day moving average.

Result (start date May 1, 2004):
Round trips: 18
Thereof profitable: 17 (1 with a loss)
Total (gross) profit: 47.05 points (1 point = USD 1,000.00) -without slippage and commissions-
Maximum exposure: 6 contracts short (6 trading days with an additional 1 contract short every day before covering those 6 contracts)
Average holding period: approximately 6 trading days
Average (Gross) profit per contract: 1.02 points = USD 1,002.00 (46 contracts shorted in total)

I took into account (included in P&L) that during 2 round trips the respective number of shorts had to be rolled over to the next contract month which led to a
loss of -3.15 index points (USD 3,150.00).

Due to the fact that concerning VIX futures the (initial) margin is USD 3,750.00,-, the (not annualized) profit would have been 26.72% for an average holding period of 5 trading days.

(may be you could verify these results yourself if you are interested in, because usually 4 eyes will see more than 2 if there has been any miscalculation)

Best regards
(I beg your pardon for not being a native speaker)

Unknown said...

Very Good Observation - here are my views sitting in Asia - I do not trade VIX Index but use it to gauge the direction and sentiment of the market and thus take position in the Asian market as they are closely correlated with the US Markets.

Using VIX I get two days of head start to trade in the market - when I come in Asia morning - I can see where the VIX had closed and then because of the mean reverting can guess what is going to happen the next day - it worked almost 70% of the time.

When used with the Historical Volatility - VIX can give very good indication of the market sentiment, like the recent rally in S&P - why - because the Historical Volatility was much higher then the VIX Index indicating the past was bad and the the low VIX level were telling us the future is not going to be as bad as the past.

visit my blog - www.optionsview.blogspot.com to red more on this topic.