Apr 27, 2020

VIX - Simple and Intuitive Explanation of Volatility Index

Few years ago I published two post trying to give simple explanations and intuition behind complicated formulas used for calculating vol indexes. However few of you emailed that some charts are missing from these older posts, and for technical reasons since I could not restore them, I decided to re-created new charts from scratch, and re-write the posts. In this post I will make many simplifications and sacrifice rigor to provide intuition behind calculations. 

There are two formulas that are used to calculate vol indexes: the theoretical variance swap formula

and its practical discrete reformulation:




While these formulas may look complicated it is actually really simple if viewed in a chart. Below are 3 charts that will illustrate step by step what the formula means, and I hope will provide intuitive understanding behind the formula. For the charts below I used simulated prices of calls and puts on a hypothetical stock with time to expiration = 0.1 and 20% annualized volatility, so we should expect the volatility index  in this theoretical example to be about 20. I plot prices of calls and puts vs strike.


Let's consider just OTM options:


The higher the perceived risk, the higher volatility will cause higher options prices, and "taller" price curves on the chart. Conversely, lower prices = lower curves. The intersections of these two curves looks like a curved pyramid. Higher prices, higher vol would create taller pyramid.


The old VIX index and any other ATM / ATMF based index has a very simple meaning - it is proportional to the height of the pyramid - red line on the chart - which is just ATM price of a call or put. Approximate formula for ATM option ( call or put ) is 0.4 *  volatility * index price * √ time to expiration . The reverse of the formula is volatility  = height of the pyramid / 0.4 / index price / √ time to expiration . In our case height is 2.53, and volatility  = 2.53 / 0.4 / 100 / √ 0.1  = 0.2 or 20% , exactly the vol we were expecting. So, in summary - ATM vol is height of the curve

Current VIX formula has a slightly different meaning - which involves an extra step. First, prices are re-weighted, or multiplied by 2/√ time to expiration  / strike2 . Then the area of the new pyramid is volatility squared. 


In our case the area is 0.04, or 20% squared, just like we expected. 

In summary - old VIX / ATM vol is the height of the pyramid, and current VIX ( or VSTOXX, or other vol indexes ) are the area of the pyramid. 

Send me an email if you want a copy of excel spreadsheet with calculations.

Interested in learning how to trade VIX futures and ETFs? Do not miss out the next great opportunity to short vol.
Find out more at VIXMon.com's trader seminars.

Apr 12, 2020

Machine Learning for Asset Managers

Marcos M. López de Prado's new book "Machine Learning for Asset Managers" is temporarily available online. Link, download link.
Check it out!

Interested in learning how to trade VIX futures and ETFs? Do not miss out the next great opportunity to short vol.

Find out more at VIXMon.com's trader seminars.

Mar 26, 2020

VIX + Covid 19 Crisis = Opportunities

Anybody who’s been even remotely following the markets over the last month knows that we are living through exceptionally volatile times.

- VIX has reached an all time peak of 83, surpassing the 2008 highs


- Crude Oil VIX (OVX) has exceeded high of 220 vol ( 190 record close )


- VIX term structure went on a record inversion


- VXX has went up almost 400% in less than a month
and so on...

With this, a simple spread trade on VXX / VXZ made over 50% in the last month ( and at one point much higher )


And this extreme volatility is not about to subside - with virus still rapidly spreading and posing tremendous health hazards, peak unemployment claims announced just this morning, and increased risk of unhealthy inflation from QE Infinity, volatility is here to stay.

So how should we trade now that the "big move" has already happened? The risk / reward calculus is no longer obvious. Veteran VIX traders who have been through 2008 may have contrarian views, and consider the current regime to yield plenty more opportunities for great trades.

If you remember, in 2014 I interviewed John Hwang (ex head of VIX trading at MS) about how to trade the VIX during market crashes. Recently, I had a chance to speak to John again, and he’s confided that he’s out of retirement, trading up to 17 hours a day, and “arbing the heck” out of the curve.

So I begged him to share some of his favorite trade ideas, and how to navigate the VIX at these levels, after the vol spike… and suggested that he republish his classic book.

Well, republishing books takes a while and because trading opportunities can go away, John has agreed not only to talk about VIX again, but to do a live training webinar to discuss unique, once in a life time opportunities to capitalize in this high VIX regime both on short and long vol sides (yes, even at this level)!

The 2 hr webinar will happen this Sunday (March 29th) at 4 PM Eastern, with an exclusive Q&A session (seats limited), and I will be joining as well. If you are interested, check out this link to find out more.

Dec 25, 2019

Bitcoin In A Year - Analysis Of Reddit Predictions

Every year for the last 7 years user BlackSpidy runs a contest to predict bitcoin price year in advance. More than predicting, the forecasts reveal sentiment and general mood of the forum about bitcoin as I will demonstrate below. While the very first year of the contest started in December 2013 yielded too few predictions, 2014 and on had enough data to be parsed.

2014 was the year of Mt Gox failure, and rumors of bitcoin ban in China, and BTC crashed from 850 to 325, finishing the year around 378 . Reddit readers predicted a median price of 700 for the end of 2015.

2015 was a slow year for BTC, trading between 225 and 350, and finishing the year at 362 . The end of the year rally inspired readers to forecast the median price of 650.

2016 was a bullish year for BTC, when it doubled over year, finishing at 753 . Sentiment was highly positive and readers predicted 1270 for the next year.

2017 was obviously a gear year for bitcoin, when it grew 9x, finishing the year at 10,859 . Excitement about the possibilities was so high that median forecast for the next year was 51,000 and even 1st quintile of the forecasts was over 26,800 . Of course looking back these numbers were never realized, not even close.

2018 was a bearish year, with prices falling to the year end value of 4,165 . Reddit readers were predicting the doubling of the price since the lows for the year end of 8,350, which is not radically far from the 7,200 where we are about now.

Obviously 2019 was a good year for BTC, but the price still has not fully recovered. Oscillations around 10k level were quite wild, and in my opinion inspired more enthusiasm for the currency. Readers are predicting 2020 price of 17,110 , more than 2x of current price.

Given the positive bias of every annual prediction - that is redditors predict 2 times the current price, and about break-even realizations of the forecast, it is hard to make a concrete conclusion. Will bitcoin indeed stabilize above 10k next year, or will the market trade up and down around 10k level?

Whatever your opinion is, I suggest you check out Deribit exchange - currently the most liquid BTC and ETH options market. Merry Christmas and good luck with your trading!

Over the last few years I have been working more and more with NLP (natural language processing), a branch of AI focused on processing of text data, information extraction, figuring out relationships between different entities, etc. If you are interested in working on project processing your proprietary data into signals, or extracting information from public or government publications, send me an email.