The Details of VIX and VXX and Dinner at Morton's

[Benton D Struckcheon]

I posted the below as a quick & dirty way to stop anyone around here who might have been looking at VXX and thinking "Hey, that looks like a bargain" before they acted:

http://www.democraticunderground.com/1121380

Now that I've done that, it's time for the detail.

We'll take apart the below, which is as good an illustration as any of the misconceptions and misinformation that people walk around with when it comes to the VIX and how to trade it:

VIX futures have expiration dates, at which point the price of the future will converge with the price of the VIX index. But because of the volatility of the index, VIX futures will rarely be priced the same as the VIX index prior to expiration. This is due to the "risk premium" being priced into VIX futures. This risk premium can be thought of as insurance cost. If someone wants to protect their portfolio from a market crash by purchasing exposure to the VIX (remember, the VIX typically moves in the opposite direction as the stock market), then the entity selling them that protection will demand a risk premium for the insurance.

From this article: The Bull Market in Uncertainty

Keep that paragraph in mind, we'll get back to it in the next post I make in this thread. For now, let's get into the nitty-gritty of what the VIX is and how it's traded. Once I'm done, the errors in the above will be obvious.

VIX = Volatility index, and is nothing but a measure of the implied volatility priced into options on the S&P.
Which means, you ask?
It's actually not that hard.
Options are the right to buy or sell something at a set price at a certain time. These things about an option are fixed:

1. The price it gives you the right to buy or sell the thing at, known as the "strike price".
2. The date at which you can do this, known as the "expiration date".
3. The price of the thing you are purchasing the right to buy or sell at, known as the price of "the underlying". The underlying can be a stock or an index or a future on that index. It can be pretty much anything for which a price is set on an exchange.

Those are the fixed things. The variable thing is the implied volatility. What that term means is how much uncertainty there is about where the price will be at expiration. If you think about it for a minute, you'll realize there's more uncertainty about Apple's price and where it will be a month or two months from now than there is about the S&P 500 index itself, and so you'd expect that the implied volatility (hereinafter referred to as "IV&quot would be higher on Apple options than on S&P options.
Right now the March Apple options that are closest to its price (the 460's, price is @459 right now) are priced at 26.36%, meaning the price has built into it the probability that Apple's price will move 26.36% on an annualized basis, both up and down.
The March S&P options, meantime, for which we'll use the 1530 here, are priced at 10% and a little bit, meaning the S&P is only expected to move around 10% up or down over the next year.
The higher the IV the higher the price of the option, because the probability of that option being in the money, that is, of the price being at a level that makes that option worth something, is greater the more the underlying moves around.
For purposes of trading the VIX, the CBOE (Chicago Board Options Exchange) set up futures on the VIX with set expiration dates. These futures trade much like options, with their value determined by where traders think the underlying will be at expiration. The difference is that they only have an expiration date, not a strike price.
These futures are based on a VIX for each month of expiration on S&P options. This makes sense, because there are March S&P options, April S&P options, and so on. The month is the expiration month for each option series.
Each will have a different IV, for a very good and very simple reason: the closer you get to the present, the more certain you are that something will happen. So, that means as you get closer to now, you would expect the IV priced into S&P options to be lower. In other words, March IV should be below April, and April IV should be below May. So in normal times you will see a downward slope in IV if you graph this.
And indeed you do:



But the CBOE throws in a twist. March futures are futures on the April VIX, that is the VIX of S&P April options. April futures are on May VIX, and so on.
Why did they confuse us like this?
Well, it's like this: VIX is a measure of everyone's guess at the future volatility of the S&P, not the past volatility, as derived from the IV priced into S&P options over the next 30 days. Right now that means it's a measure of a mix of options with a March expiration and an April expiration, as March expires 28 days from now, while April expires 56 days from now. (The logic behind the expiration date is actually pretty straightforward, as you'll see below.) So mostly it's March, with a little bit of April thrown in. As you can see from the above, March is at 11.92, which is pretty close to VIX as I write this, which is 12.31. April VIX, which you can see from the above is resting at 12.99, is somewhat further away.
Now the expiration dates I just gave you are for VIX futures, NOT S&P options.
Take a minute to digest that, it's important.
S&P options have different expirations, generally, though not always, the Friday AFTER the VIX expiration, as VIX futures - and VIX options - expire on Tuesdays, not Fridays. That means the VIX for any particular month is always only coincidentally equal to the VIX value quoted on any given day, even if that day is VIX expiration day. Because the VIX, remember, is the IV of S&P options, and is a calculated 30 day figure derived from those options that, like today, are expiring both before and after the 30 day interval the VIX is calculated on. Only when you are EXACTLY 30 days away from S&P options expiration day for the series that is expiring next does the VIX = the IV of any particular S&P options. That day is the day VIX futures and options expire on. BUT - and this is a huge but - the way the expiration value is calculated is by taking the opening price of the S&P options on that month, not the closing price. This introduces a pretty large uncertainty into where this calculation will be. It's called the Special Opening Quotation by the CBOE, or the SOQ. So VIX futures and options always have to price in a certain amount of uncertainty because the SOQ is so weird and it's pretty unpredictable where it will land. The SOQ is on the options expiring in the month AFTER the futures because that is the month that will be 30 days away on that Tuesday morning. That's why March VIX futures are on April S&P options.

If you're thoroughly confused, don't worry. You should be. If this stuff were easy, I'd be broke. And I don't like being broke.

Now, if you speculate in VIX options, which is far more common than speculating in VIX futures, not the least because you can count on the fingers of one hand the brokers who support direct speculation in VIX futures (you need good lawyers to support that, believe me) then you have to remember that VIX March options may be on VIX March futures, but those futures are based on April VIX, not March VIX, and design your strategy accordingly.

Now to VXX.
VXX was invented so that people who wanted to take a flyer on VIX wouldn't have to think about all that stuff I just posted up there. Except it's a truly horrible thing.
Look at the graph above as I explain this. VXX does the following: it progressively sells out of the front month VIX futures to buy the second month futures. That means right now the managers are selling March futures to buy April futures.
Now, if futures on the coming month are higher than futures on the month about to expire, which they are most of the time, since, remember, the closer you get to the present the more certain you are that something is going to happen, and that means the IV priced into the options will be lower the closer you get to the present, that means you are - get ready folks - selling low and buying high.
This is the precise opposite of what a guy like, to take a random example, Warren Buffett might do: he aims to buy low and sell high. Notice that every year Buffett gets richer, mostly. Notice as well, that every year, as illustrated by the graphs I posted in the thread The Dangers of VXX, VXX gets poorer, mostly. Until people consistently are more certain of stuff happening two months from now than they are of stuff happening a month from now, that will be true. In other words, it will pretty much always be true.
Guys like me make money by taking advantage of VXX and the folks who buy it. You might want to do that too, thinking it's easy. It's not. If you don't know options and don't have experience trading them, all you're doing is setting yourself up to finance my next dinner at Morton's. You won't feel good about it, trust me on this.

Next, we'll take that paragraph I quoted at the beginning apart, and introduce a little math - not much, just a little - to help in its shredding.

[Benton D Struckcheon]

1. Taking apart that paragraph

As noted above we will now take this paragraph apart:

VIX futures have expiration dates, at which point the price of the future will converge with the price of the VIX index. But because of the volatility of the index, VIX futures will rarely be priced the same as the VIX index prior to expiration. This is due to the "risk premium" being priced into VIX futures. This risk premium can be thought of as insurance cost. If someone wants to protect their portfolio from a market crash by purchasing exposure to the VIX (remember, the VIX typically moves in the opposite direction as the stock market), then the entity selling them that protection will demand a risk premium for the insurance.

The first sentence has this error: the price of the future will converge with the price of the VIX index.

If you trade the VIX futures or options and are using that as your guide, you will be inaccurate.
What actually happens is that the VIX of the month the futures are for, which for the current front month futures, March, is the VIX of April, is that that monthly VIX becomes the VIX on the day of expiration because it's deliberately timed that way. At all times the March futures will be priced off the April VIX, and any calculations you do on those futures that use the regular VIX quoted in public will be off.

The second sentence is far worse:

But because of the volatility of the index, VIX futures will rarely be priced the same as the VIX index prior to expiration. This is due to the "risk premium" being priced into VIX futures.

This is so bad it constitutes financial malpractice.
VIX futures are very much like VIX options in this way: they have all of the characteristics of an option, such as vega, gamma, theta, and delta, except that unlike an option with a strike price they ALWAYS trade out of the money when you refer them back to the VIX of the month they are actually for. Since options have a strike price they can wind up so far in the money that the time value disappears prior to expiration. They can also end up so far out of the money they become worthless prior to expiration.
This NEVER happens to the VIX futures, since they don't have a set strike price.
SO, just like an out of the money option, there will be a time value built into their price right up until the day of expiration. Unlike most OTM options, that time value will be non-trivial because of the Special Opening Quotation (SOQ) mechanism I explained in the first post, which introduces an extra layer of uncertainty. The SOQ means the premium will continue right up until the SOQ is published by the CBOE. Only then will it go away, and the price of the futures finally settle. The "risk premium" he refers to exists because of this uncertainty, which is indeed a product of the seller demanding a premium, but that premium always exists for the life of the future, and it does so because no one, including the CBOE, knows precisely where the SOQ will end up until it's calculated and published on the morning of expiration.
So, it isn't true that the futures will "rarely" be priced the same as the VIX: if you refer them to their proper monthly VIX, they will NEVER be priced the same. There is ALWAYS a time value in the futures. If you actually trade VIX futures as this guy says he does and don't know this, you're setting yourself up to be skinned.

The rest is just boilerplate. The point is the VIX has a lot of little details that will seriously trip you up if you don't pay careful attention, and given the variability of this index you really really don't want to be playing with anything that is related to it if you don't have all those little details nailed down.
Most people, including most pros, are better off staying away. There's far easier ways to make money in the market, and certainly far easier ways to lose it too.