Aug 13, 2010

Understanding VIX Futures Movement, Part 3

Part 1 here, part 2 here. In the previous post I described decorrelation of VIX futures over time. In this post I will discuss the the decay, or theta of futures.

Surlytrader writes "Consider this the cost of holding the long position over time. This is important because we can think about VIX futures trades much like we think about calendar spreads in the options world. In a calendar spread you buy a longer dated option and sell a short dated option. You hope that the short-dated option decays (loses value) quicker than the long-dated option. In addition you hope that your purchased long-dated option covers you against adverse movements on the short position in the short-dated options. "

Indeed, VIX futures do behave like options. Unlike "regular" index futures, VIX futures are non-linear in the index. That means that besides delta VIX futures also have gamma and theta. The last one is the most obvious, and is indeed observed in the marketplace. As one can see, most of the price decay occurs closer to expiration. The applet below demonstrates VIX daily decay as a function of different parameters.

If you do not see the applet above you may need to download shockwave player from Adobe (same company that makes Flash player, and Pdf reader)

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