Implied Volitility

[VolSkewTrader]

Good question VolSkewTrader

What to do now with the VIX this low.

The VIX below 12.5 has only triggered our backtester 18 times.

I have backtested the strategies you mentioned as follows.

1. Buy VIX futures if VIX under 12.5 and sell if gets above 15, 17.5, 20 or 25.

For starters if you were able to buy the VIX cash when it fell under 12.5 and sell when it went above 15, 17.5, 20 or 25 you would do very well. Here are the results for the best of those selling when the cash VIX went above 17.5:

Being unable to buy the VIX cash, what is the best alternative? I can list out some alternatives if people are interested but the returns will not be nearly this good because what VolSkewTrader mentions:

- Trades at a premium to the cash, can only replicate the cash instrument through the OTC variance swap market

- Lose money on the roll yield due to unfavorable VIX term structure


2. Buy VIX calls if VIX under 12.5. 30 days to expiration (DTE) 30 delta calls held to expiration does poorly with a -13.07% Annual Return. Our annual returns are based on profit/stock price, slippage and commissions are considered as explained here.

3. Buy SPY OTM puts if VIX under 12.5. I chose a long term 1-year put with a low delta of .05 returned a -0.04% annualized return.

4. Buy SPY cheap calls and delta hedge. I backtested buying 6-month OTM 0.05 delta calls, delta hedging every 5 days when the VIX was under 12.5 and exit the position when the VIX went above 17.5. This returned -0.03% annually.

5. Buy a SPY 1x2 put backspread. I used a short 0.40 delta put and two long 0.20 delta puts at 45 days to expiration in the backtest, and entered the spread when the VIX was under 12.5 and held the position to expiration. The strategy returned -0.6%.

6. Buy a SPY straddle 30 DTE hold to expiration when the VIX goes below 12.5 returned 0.27%.

7. See #6

8. Buy UVXY when the VIX goes below 12.5 and exit when the VIX goes above 17.5 returned -4.01%.

So my choice would be to find the best VIX future to buy in this scenario.

If you want to see these backtests and run some of your own, signup for a free-trial and message me. I can send you links to the backtests which you can edit or run new ones.

Thanks Matt from Orats for doing all the heavy lifting for me, lol. I really appreciate it. Sounds like you guys have a nice back-testing product. Can I use it for other products such as gold, WTI and Brent Crude, grains, treasuries, etc.?

If I were to outright just buy VIX futures if they got close to 10, I would lose on the roll yield over time waiting for the SPX to collapse. But if I took advantage of the current steep term structure/VIX contango and bought the cheap front month and sold the expensive back month, this would be a conservative bet on a correction higher in the VIX Index. When volatility explodes, the front month VIX futures tends to move more one-to-one with the VIX cash, while the back months remain more "sticky" in price as they reflect where the VIX will mean-revert when volatility comes back to earth. The long front/short back month VIX strategy should work when the VIX bottoms out.

 

[VolSkewTrader]

When I thought vol was too low...

9- Load the boat, dynamically hedge daily attempting to make back a little more from gamma than you lose on theta (which if you are correct, and vol is too low, you should be able to do). Wait for the pop.

Preferably I'd still go 1*2 puts and 1*2 calls as it pains me to own the ATM, and this way if I am right, I move towards my longs and get longer vol as it's popping. God how I love those 2nd and 3rd derivative moves such as vega delta on vol change.

I agree with your first strategy, but I don't want to manage a long gamma position on something I'm not watching every minute of the day. Plus I'm a terrible futures/stock/underlying scalper. I'd like to have something more passive, and not have to fight the time decay everyday.

The put and call ratios are something I would lean toward. However, it sucks paying the "skew theta" for the put ratios, and the call ratios don't make enough money on the gap moves lower because we're moving too far away from them. If IV is low enough the put ratios should pay out handsomely on an SPX/SPY correction due to their juicy Vomma/Volga characteristics, which you smartly pointed out. Just wish the put skew/slope wasn't so steep on these vol imploding rallies.

 

[Wheezooo]

Technically speaking, passive or aggressive, you are fighting time decay regardless. Just put in a MOC order and flatten on the close. It's doubtful you do better than that actively managing, anyway.


...back in my day... people yelled at you for saying things like options had skew. There were only two companies I knew of that insisted on modeling it. Needless to say, they eventually dominated the options market. People see that weird theta decay relationship and don't understand it is a theta you are paying for what you call Volga/Vomma. As I like to say again and again, with options you pay for everything. Nothing is free and all advantages are removed as fast as possible.

 

[VolSkewTrader]

When I thought vol was too low...

9- Load the boat, dynamically hedge daily attempting to make back a little more from gamma than you lose on theta (which if you are correct, and vol is too low, you should be able to do). Wait for the pop.

Preferably I'd still go 1*2 puts and 1*2 calls as it pains me to own the ATM, and this way if I am right, I move towards my longs and get longer vol as it's popping. God how I love those 2nd and 3rd derivative moves such as vega delta on vol change.

You said you didn't like to own the ATMs, neither do I unless I know we're going to move away from them. Did you always like being short ATMs vs being long the OTMs/wings - long the butterfly at all times? And were you always long OTM calls vs short OTM puts like most SPX groups.

 

[Wheezooo]

"Did you always like being short ATMs vs being long the OTMs/wings - long the butterfly at all times?"

Yes! 100% of the time. All time frames. Just got wider as I moved out on the curve. Like a giant wedge.

"And were you always long OTM calls vs short OTM puts like most SPX groups."

No. Although I am speaking generically, as the SPX was never my focus. Normally on the negative side of the skew I would sell the 20 - 30 delta and then again LOAD the boat with the 10's on down. I never met a teenie I didn't want to own. That way I kept my VAR in check for cheap. My #1 rule of options is never allow yourself to have a position on with catastrophic risk.

I am also not a fan of that "vol always up when market down and vol always down when market up," one-size-fits all indoctrination, for 2 reasons:

1- At real low vol, with a negative skew to boot. Where the f' is vol going to go if the market moves towards the weak side, and moves that way fast? Throw in most MM are short it and I've seen it pop plenty of times as they go into gamma panic and the clearing house starts making calls. So the weak side had a lot to do with levels and what I think the market-makers position is. Weak handed, under capitalized traders can really F you if you have your position on the same way as them.

2- Again, if vol is low and market is in unfamiliar territory, it's likely you can clean up on gamma, and who cares if vol comes in a vol or two. Then when it gets to your longs, roll them down as fast as you can in case you sit there.

All this is being said from the perspective of someone who thinks you should expect to lose on your position, and it is more important your position be designed to keep you always flexible enough to trade (and allows you to sleep). Although it would be impossible to quantify it, I know I did very well on positions, but I still like to think I lost on my positions and made my money trading.

 

[VolSkewTrader]

"Did you always like being short ATMs vs being long the OTMs/wings - long the butterfly at all times?"

Yes! 100% of the time. All time frames. Just got wider as I moved out on the curve. Like a giant wedge.

"And were you always long OTM calls vs short OTM puts like most SPX groups."

No. Although I am speaking generically, as the SPX was never my focus. Normally on the negative side of the skew I would sell the 20 - 30 delta and then again LOAD the boat with the 10's on down. I never met a teenie I didn't want to own. That way I kept my VAR in check for cheap. My #1 rule of options is never allow yourself to have a position on with catastrophic risk.

I am also not a fan of that "vol always up when market down and vol always down when market up," one-size-fits all indoctrination, for 2 reasons:

1- At real low vol, with a negative skew to boot. Where the f' is vol going to go if the market moves towards the weak side, and moves that way fast? Throw in most MM are short it and I've seen it pop plenty of times as they go into gamma panic and the clearing house starts making calls. So the weak side had a lot to do with levels and what I think the market-makers position is. Weak handed, under capitalized traders can really F you if you have your position on the same way as them.

2- Again, if vol is low and market is in unfamiliar territory, it's likely you can clean up on gamma, and who cares if vol comes in a vol or two. Then when it gets to your longs, roll them down as fast as you can in case you sit there.

All this is being said from the perspective of someone who thinks you should expect to lose on your position, and it is more important your position be designed to keep you always flexible enough to trade (and allows you to sleep). Although it would be impossible to quantify it, I know I did very well on positions, but I still like to think I lost on my positions and made my money trading.

Thanks for that sage advice. Not as big a fan of the "teenies", but your argument makes sense. Otherwise, I agree with everything you said.

I do like getting long when it's getting annihilated, it's always overdone. And I hate chasing to buy it when vol is going up. Nothing worse than racing everyone to buy (reach for) puts on the break. An algorithm that always trades on the side of "smart" paper and takes the opposite position of under-capitalized "panicky" traders would clean up....I'd put my life savings into something like that.

My biggest problem and weakness as a trader is that I don't like to just hit the bid or lift the offer when I need to get out of something or lock in a winner. Like your example of when you go to your longs and vol is pumped, I am too stubborn to just hit the bid and lock in the winner, and instead will wait in vain for at least a mid-market bid or try and work my offer, and then end up chasing it down when it's going against me. I think this has been ingrained in me from my days as a floor trader, when you were crucified if you even traded mid-market. I've had to re-invent myself making the transition to the screen.

The long butterfly position has been working for me. It's the risk reversal and floating skew trade/position management that I really need to work on. Trading on the floor was such easy money, like taking candy from a baby. Trading on the screen with ultra-tight, almost choice markets has been challenging to say the least.

 

[Wheezooo]

Well some Italian dude once said "there is no greater mastery than mastery of oneself." (Although he probably said it in Italian and I think the second mastery might have been a bad translation leaving out the suffix 'batery')

Short of that - Simple solution. You bought X vol. Vol is now X+8 so set your model not to market, but to X+7, and sell away!!

I learned patience and risk management in options, but discipline getting in and out of trades, I learned watching the best futures traders. The guys that are balls to the wall long, realize things aren't doing what they should based on the reason they believed it should, don't rationalize things telling themselves to believe what they want to believe, and a second later, their not flat, but short, and all without any apparent mental conflict of the fact they just did a 180. That always impressed me.

...and yes, it amazed me how many excellent floor traders couldn't do a damn thing once they couldn't see the paper flow. Particularly futures traders. I was an options trader by brain, but a futures trader by heart. There was nothing more fun than running out of the options pit and freaking out all the futures traders by jumping into their pit, screaming like a maniac, waving my hands all over the place, and executing my own futures. They were a more fun bunch of guys than the options guys.

...and teenies really are the greatest thing in the world. Just gives me the warm fuzzies typing the word.