Volatility Futures & Options: 07/01/2011

VIX Options Skew

I just came across an excellent piece of research by a team of Barclays quants. The document is available here. Although the main topic of the document is about hedging, there are interesting empirical observations about VIX volatility surface. The juicy stuff starts on page 10, and is summarized on page 20. Below are the main points:

Skew of VIX options is independent of underlying level
VIX ATM IV is highly correlated with SPX skew (now that there is an index for that I would like investigate this further)
How to properly calculate realized volatility of the VIX. The authors write that "calculating realized volatility of VIX futures is complicated because the underlying VIX futures are systematically more volatile with decreasing time to maturity" Their solution is to calculate realized volatility of the futures contract following the forecast date.
To model VIX ATM IV they use a simple model of VIX realized volatility and SPX skew. Term structure of ATM volatility is calculated with exponential extrapolation (there are two unknown parameters - long-term vol of vol level and smoothing parameter alpha). Skew of the VIX options is linear in futures level and extrapolated to different maturities using √T

The rest of the paper deals with hedging. There is an interesting chart on page 26 on predictability of VXX returns based on VIX / VXV ratio, which is contrary to my own research. I wonder about their exact method, and plan to research this more.

Volatility Forecasts

Month over month VIX was almost unchanged, falling from 19.73 to 19.10, while VSTOXX rose from 23.06 to 27.65 underlying high uncertainty about economic situation in the Euroblock. My forecast for the VSTOXX to rise was spot-on, although the index rose much higher than I anticipated. VIX was lower than I thought, but the forecast I provided last month was only 0.61 cents away from VRO.

For the next month I predict VIX to close at 20.45 vs 19.35 in futures, and VSTOXX to close at 27.96 vs 26.45 in futures. As before you can follow my forecasts on the forecast tracker page.

And The Winner Is ...

I am super-excited to announce the winner of volatility forecasting contest. VRO printed out this morning at 19.10, making reader Vamsi the winner of $100 prize (forecast 18.44 was closest with difference of 0.66 = |18.44-19.10| I will hopefully be able to get their perspective on VIX forecast. Meanwhile I should note that my own forecast of 19.71 came only 0.61 away. You can follow my monthly volatility forecasts here.

UPDATE: Vamsi described his personal trading in a private email:

I have been trading VIX related products pretty much from the time VIX futures were introduced. My trading style is Global Macro. My main strategy is to run a short vol book with hedges from commodity, forex and interest rate markets, wherever I see relative value. The key is risk management. The gains take care of themselves.
I don’t forecast VIX levels and trade off these levels. My entry was just where VIX probably closed for the day. I entered the context because I love free options and one of them ended in the money today!

Applets Are Working Again

In a series of previous posts on Understanding VIX Futures Movement (part 2, part 3) I created applets that you can plug in your own parameters and see how the term structure responds to them. Sometime in the last two months the website that I used to host applets has terminated my account, so I re-uploaded them to a different website. You may need to install Adobe Shockwave to view the applets, or try a different browser (on my computer applets work on Chrome, Firefox, and Safari, but not on Internet Explorer) Thank you to reader James for pointing out the problem.

Week in Volatility

If feels after relatively bullish start market got spooked at the end of the week, VIX futures, VSTOXX futures were up across the board. Implied volatility for VIX options also rose, which made for a stressful day for me on Friday. Front month options are set to expire on Wednesday morning, after which I will update everyone on the volatility forecasting contest we started a month ago. For now, I think that VIX at 20 is a more "fair" value for the index rather than 15, but flow seem to be shorting vol no matter how low VIX is.

After a strong start the volume on RTSVX started to drop. I hope this is a temporary disruption, and that futures trading continues to grow. I ran my model few days ago on the futures, and found that they were fairly valued, unfortunately I do not have trading access to Russian markets.

Free Issue of Expiring Monthly

This is a free best of the first year issue of Expiring Monthly magazine. The articles include: 1. The Volatility Risk Premium in Commodity Options - by Jared Woodard. The author reviews existing academic research and adds his original research on the topic of volatility premium in different commodity markets. Overall I am familiar with the most content of the article from JW's Options and The Volatility Risk Premium ebook, which is a lot more thorough. 2. The New Option Trader Risk Management - by Mark D Wolfinger. The article is about emotional aspects of trading and risk management. I found this article be the most interesting to me, even though I am an experienced trader! 3. Interview with Sheldon Natenberg, author of Option Volatility & Pricing - by Mark Sebastian. There are few points about changes in the industry, penny pricing, impact of high frequency trading. I think the book is currently outdated; and the best book for beginner options trader is Option Trading by Euan Sinclair. 4. Bill Luby describes VIX/VXX ATM Calls spread. Note possible typo: I think "short VIX December 44 calls for 3.10" should be "short VXX ..." It is somewhat "messy" way to play seasonality, and I did have a VIX diagonal on at that time. The article is very informative in describing day by day decision process about managing the position. 5. Trading Advice From a Different Perspective - by Mark D Wolfinger. When do exit? When do you take a loss? MDW provides a framework for answering these (sometimes very difficult) questions. He summarizes it "Your job as trader and risk manager is to make money in the future. You cannot change the past. If you do not believe your current holdings can do the job — or are too risky to take the chance — then your job is to exit now and make a better trade when you find it." If I may add something is that I developed a simple mathematical framework to analyze optimal exit points, and what I found that the optimal decision is always either exit right now, or wait until expiration; it is never something like "wait 2 days, and then exit" 6. Trading The Hard Side - by Mark Sebastian. How to "work" SPX option orders for better execution. I really hope all SPX goes electronic soon so shitty executions will be a thing of the past. 7. An Introduction To Options On Interest Rate Products - by Jared Woodard. 8. Evaluating Volatility Across Asset Classes - by Bill Luby. The author compares behavior of different volatility classes during extreme events. That is an important topic but I disagree with his approach: normalization as described in the article is backwards looking, and results may be misleading. 9. Interview with Tim Andriesen (CME) - by Mark Sebastien 10. On Eating What We Kill - by Jared Woodard

Are Other Volatility ETFs At Termination Risk?

I think that is really the question to ask after VZZ dropped below $10, triggering automatic termination. The prime suspect is TVIZ index that is also a 2 X version of Mid-Term VIX Futures Index, although unlike VZZ it is rebalanced daily. While VZZ is (was) issued by Barclays, TVIZ is from VelocityShares (Credit Suisse). I searched for any info on termination in the prospectus and product page, but could not find an automatic termination clause (Note that all VelocityShares ETFs share the same prospectus)

Vance at Six Figure Investing already covered the topic of termination in great detail on IVO and XIV ETFs. The only thing that I may add is that looking at the list of volatility-related products it does not appear that any of them are in the immediate danger of termination. VelocityShares are rebalanced daily and do not seem to include automatic termination clause. Short volatility ETFs that do have "acceleration" are probably safe, unless we see a major major market disruption event.

VZZ Terminated

Falling volatility caused VZZ ETF, which provides double leveraged (since inception, not daily) returns of VIX Mid-Term Futures Index, to fall below $10, causing automatic termination. As Barclays writes (note, prospectus)

"As a result of the occurrence of an automatic termination event on July 1, 2011 Barclays Bank PLC will automatically redeem its iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETNs. The ETNs will be redeemed (in whole, but not in part) on July 11, 2011, the date which is five business days after the automatic termination date, and the payment upon redemption will be a cash payment equal to the closing indicative note value on the July 1, 2011, representing the automatic redemption value as described in this pricing supplement. The automatic redemption value shall not be greater $10.00 for each ETN and shall not be less than $0 per ETN."

VZZ has mostly accurately tracked the 2 X performance of VXZ, falling 67.35% since its first close vs 33.70% for VXZ. S&P 500 rose over 11% over the same time period.