Thursday, August 16, 2012

A VIX Risk Reversal

With the VIX at about 14.50 as I type this and a large group of investors convinced that stocks are overbought and/or not properly discounting global macro risk, many are wondering just how to translate their beliefs into an effective trading strategy.

For those who think a long volatility trade is the answer, there is the issue of the significant contango headwinds, where a negative roll yield will pummel net asset values on VIX options and VIX exchange-traded products as a part of the daily rebalancing process, while VIX futures are subjected to a similar decay that reminds me a little bit of a dying helium balloon. Long story short: there is a huge daily penalty being assessed just for holding these long positions.

There are ways to minimize the effect of negative roll yield and typically one of the best of these is to work with positions that focus on the more distant months of the VIX futures term structure. This is generally why VXZ outperforms VXX over an extended period. Unfortunately for aficionados of VXZ, the negative roll yield between the fourth and seventh month VIX futures (VXZ buys the seventh month and sells the front month each day) hit a new record on Monday and continues at near record levels.

So what is a long volatility trader to do?

One trade that I somehow have never managed to highlight in my 5 ½ of writing about the VIX is a VIX risk reversal. A risk reversal is essentially a synthetic long position in which a trader uses options to create a position that is similar to owning the underlying, but typically ties up less capital in the process. In the case of a risk reversal, this means selling out-of-the-money puts and buying out-of-the-money calls. In many instances, the sale of the put options will finance 100% of the cost of the calls.

While the VIX is currently trading at 14.50, keep in mind that the best proxy for the price of the underlying for VIX options is the VIX futures for the corresponding month. So, with the September VIX futures at 18.95 at the moment, one could sell the September 18.00 puts for 1.50 and buy the September 24 calls for 1.05, pocketing the 0.45 differential. A more conservative trader might look to sell the VIX September 16 puts for 0.55 and use the proceeds to pick up a September 30 call for 0.55 or to defray some of the costs of the purchase of a more expensive call, such as the September 24 (priced at 1.05) mentioned above.

There are ways to turn this idea into a more aggressive trade as well. One approach is to morph a risk reversal into a leveraged trade in which more calls units are purchased than put units are sold. An example of this approach might involve selling the September 19 puts (which are currently at-the-money) for 2.15 and using the proceeds to purchase two contracts of the September 24 calls for 1.05 each.

A risk reversal also goes by other names, notably a long combination (or long combo) and, despite the name, is a high-risk trade that is vulnerable to the ravages of time decay. This trade is not for everyone, but can be a good way to generate significant long exposure with a minimal outlay of funds and sometimes no outlay of funds at all.

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Disclosure(s): long VIX at time of writing

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