This Volatility Options Bet Also A Hedge

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.

U.S. equity markets have seen historic volatility during the past week, and when that happens, investors turn to the VIX to learn just how much volatility is expected during the next 30 days.

The VIX is a measure of the implied volatility of options on the S&P for the next 30 days. The VIX index measures implied volatility using hundreds of option prices, and since the weighting between the front month and the second month is changing constantly in order to maintain an index with precisely 30 days to expiration, the VIX can’t be replicated.

Price Gap
This inability to replicate the VIX index generates substantial difference between the VIX index value that everyone sees in the media and the price of VIX futures contracts that actually allow exposure to the VIX.

For example, the VIX Index and settlement values for VIX futures as of the close on Thursday:

Since VIX futures are the only way to express an investment point of view, they’re usually the underlying security for VIX ETFs.

Thus, this difference between the VIX index and the price of VIX futures is transmitted to VIX ETFs. That means that VIX ETFs often post surprising results when compared with the VIX index. For example, on Thursday, the VIX index fell by 13.92 percent, while the iPath S&P 500 Short-Term Futures ETN (VXX | B-62) rose by 2.45 percent.

To Go-To Volatility ETF
VXX is the most popular volatility ETF among traders with average daily volume over 60 million shares. VXX seeks to provide exposure to the S&P 500 VIX Short-Term Futures Index, which maintains a position in the front two futures contracts while constantly rolling from the front month to the second month as the front month nears expiration.

Given the turmoil of the last several days, VXX has performed as you’d expect. You can see the three-month chart below:

While VXX is based on a measure of the price of S&P options, options on VXX itself are also very popular, and on Thursday, one VXX option trader made a bet that the volatility we’ve seen hasn’t reached its peak.

$1.62 Million Trade
Just after the open on Thursday, our trader paid $4.59 to buy 3,540 of the VXX $32 strike call options expiring in March. These call options give the owner the right, but not the obligation, to buy 354,000 shares of VXX at $32.00 per share any time before the options expire in March. For this right, the option buyer paid a total of $1.62 million.

Since the call buyer paid $4.59 per share, the breakeven price for these calls is $36.59; if he holds these options to expiration, VXX has to be above $36.59 or he’ll lose money. But the $4.59 spent is the maximum loss while the maximum profit will continue to increase as VXX continues to increase in value above $36.59, as you can see:

It’s easy to think this trade is a speculation on where VIX is headed between now and March. But since the VIX and the S&P 500 Index tend to move in different directions, it can also be a hedge against a decline in a portfolio that tracks the S&P.

In many ways, over the short term, VIX is a wonderful means of hedging long exposure to the S&P, since the correlation of the VIX to the S&P is about negative 70 percent. And buying calls means that if the S&P portfolio were to recover and rally, the hedge wouldn’t eat up all that recovery in the S&P.

There Is A Cost
This hedging and defined risk from buying VXX calls comes at a cost. The VIX is very volatile, as you’d expect. That means VXX options are very expensive. These VXX options assume VXX will have annualized volatility of about 79 percent during the term of the options. That’s more than four times the amount of volatility we’d expect from the S&P itself during the same period.

VIX can be a nice hedge against declines in the S&P despite the structural problems facing investable products like futures and VXX. Coupled with options on VXX, it’s a powerful but expensive strategy.

At the time of writing, the author did not have a position in VXX but was short S&P implied volatility. NationsShares is the creator of VolDex, an implied volatility index that competes with VIX. Follow Scott on Twitter @ScottNations.