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21 November 2012

VIX Risk Reversal: Capturing the Imagination of VIX Options Traders

There haven't been many ways to play volatility on the long side this year without getting hurt by the term structure, whether it is in the form of the monthly futures roll, options time decay or the negative daily roll yield faced by exchange-traded products.

This year will go down as the year in which everyone was waiting anxiously for the seemingly inevitable VIX spike that — at least through the October options expiration cycle — never materialized. As a result of these dashed expectations, investors have been dramatically overpaying for long positions in VIX futures, options and exchange-traded products along the way, riding the slope of the term structure down and incurring substantial losses in the process.

Frankly, there have not been many ways to play volatility on the long side this year without getting hurt by the term structure, whether it is in the form of the monthly futures roll, options time decay or the negative daily roll yield faced by exchange-traded products.

Risk Reversal Overview

One strategy that always seems to capture the imagination of VIX options traders is a long VIX risk reversal, which is also known as a long combo. A long risk reversal is a two-leg position consisting of a long call and a short put. Traditionally, both the call and the put are out of the money. The position loses money at expiration if the underlying slips below the put strike and makes money at expiration if the underlying moves above the call strike. The profit and loss for this position at expiration when the underlying expires between the put strike and the call strike is determined by the difference between the proceeds from the put sale and the cost of the call purchase.

Traders often seek to establish a symmetric position when trading risk reversals. For instance, one can trade roughly equal deltas, such as dual 20 delta strikes or 30 delta strikes. Alternatively, the focus may be on percentage OTM, such as 5% or 10% OTM strikes for both options. While I have traded VIX risk reversals with strike selection dictated by deltas or percentage OTM, lately I have been experimenting with a different approach that allows for dynamic strike selection, based upon the VIX futures term structure.

Below, I outline one relatively inexpensive way to build long volatility exposure via a risk reversal strategy and begin to track the effectiveness of this strategy over time in what I anticipate will be an ongoing longitudinal examination of this approach.

The VIX Term Structure Twist

While there is an intuitive appeal to trading puts and calls with strikes that are equidistant from the underlying in terms of deltas or percentage out of the money, as a veteran VIX options trader I know that there are times when I may want to adjust the strike selection to match market conditions. Interestingly, the VIX futures term structure, which just happens to be the best framework for evaluating the underlying for VIX options, also fluctuates with market conditions, providing information on how investors are thinking about future volatility trends and also making it easier to determine how cheap or expensive various VIX option strikes and expirations are relative to each other. The result is that the VIX options landscape and the opportunities it presents are much different when the VIX futures are in "contango" (the front month is cheaper than more distant months) than they are when the VIX futures are in "backwardation" (the front month is more expensive than more distant months.) Specifically, when the VIX futures are in contango, investors are anticipating that volatility will increase, and VIX OTM calls can be very expensive as a result of consensus expectations. Conversely, when the VIX futures are in backwardation, investors are predicting that volatility will decline over time, and consequently, VIX OTM calls can be relatively inexpensive.

With this in mind, I have been experimenting with using the VIX futures term structure as a means by which to determine the strike selection for VIX risk reversal trades. Further, by rolling these positions on a monthly basis, the strike selection becomes dynamic and asymmetric as market expectations expand and compress the extrinsic value of options.

Trade Approach: VIX Risk Reversal With Strikes Determined by VIX Futures Term Structure

While it is natural to think about using the VIX futures term structure to establish a calendar spread or diagonal spread, I want the risk reversal trade I am looking to implement to utilize the same expiration so that I can roll both legs at the end of each expiration cycle. So instead of using, for example, the front-month VIX futures to determine the strike selection for the short put leg and the more distant month to determine the strike selection for the long call leg as well as the corresponding expiration month, I am limiting this trade to the front month only.

In looking at alternative strikes, I have elected to use the front-month VIX futures to select the short put leg and the fourth-month VIX futures to select the long call leg. In order to push the strikes farther away from the underlying, I have chosen to round down the front-month VIX futures to the next-lowest strike and round up the fourth-month VIX futures to the next-highest strike.

Structuring the VIX Risk Reversal Trade

I launched this “proof-of-concept” trade strategy on September 19, at the close of the first day of the VIX October expiration cycle. On that date the VIX front-month futures settled at 16.05 and the fourth-month futures settled at 20.80. Just before the close, I went short one October 16 put (0.3% OTM) for 1.275 (bid-ask midpoint) and went long one October 21 call (30.8% OTM) for 0.625. See Figure 1 for a summary of this initial transaction, as well as a snapshot of the VIX and SPX at that time.

Figure 1: VIX Risk Reversal Trade Summary Table

Source: Livevol, VIX and More

Position Monitoring and Rolling

In Figure 1 (above), I have also captured some closing values for three additional trading sessions. October 16 is the day prior to the VIX futures and options expiration, when these products can last be traded. At this point the trade is down a nickel. On October 17, the put leg settles 1.04 in the money and absorbs the entire 0.65 net proceeds from the beginning of the cycle, plus an additional 0.39. By the close, however, the VIX front-month futures are up to 16.45 and the fourth-month futures are at 20.05, so I end up with a new short put position and long call position at the same strikes for November. This time the November 16 put is sold for 1.20 (2.7% OTM) and the November 21 call is bought for 0.55 (27.7% OTM). The net proceeds bump the cash for this strategy back into positive territory at 0.06.

The last entry in Figure 1 shows what happened to the position on October 19, when the VIX spiked 12.9%. Here, the shrinking value of the call jumps dramatically, while the value of the put declines substantially, pushing the cumulative profit and loss of this risk reversal strategy to its biggest gain since the initial transaction.

Figure 2 (below) shows the movements of the VIX (index) and SPX during the October expiration cycle and the November expiration cycle through October 19.

Figure 2: VIX OHLC Chart for October and November Expiration Cycles

Source: StockCharts.com

Initial Observations

My intent is to periodically update the data from this trade. At this stage it is too early to evaluate the effectiveness of this VIX risk reversal strategy with a term structure twist. Hence the longitudinal approach. Clearly things will get interesting if the VIX term structure moves into backwardation during the period covered by this strategy, and it will be interesting to see how the strategy performs in that environment.

Apart from this particular implementation of a VIX risk reversal, I am also conducting similar proof-of-concept strategic experiments using deltas and percent OTM for strike selection. I am also experimenting with some other term structure approaches and look forward to a comparative analysis in a future article.

Bill Luby is a featured contributor to Expiring Monthly. He is a private investor whose research and trading interests focus on volatility, market sentiment, technical analysis, and ETFs. Luby’s work has been quoted in the Wall Street Journal, Financial Times, Barron’s and other publications. Luby has been trading options since 1998.

Further Reading From Expiring Monthly:

“Investing Implications of the VIX Term Structure,” October 2011

“Calculating the Future Range of the VIX,” February 2012

“The VIX Term Structure as a Predictor of Future Returns,” March 2012

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