Monday, December 6, 2010

VIX Put Matrix Offers Glimpse of Expected Future

In yesterday’s, Chart of the Week: VIX Support, I made a statement that several readers have had some difficulty putting their arms around.

Specifically, I noted:

“VIX puts are extremely inexpensive right now and one can actually buy VIX puts for March, April and May of 2011 for less than half the price of what the December 2010 puts are currently being offered.”
This strange, but true phenomenon arises because of the confusion over the underlying for VIX options. At the moment VIX options expire, the underlying for the options is indeed the cash/spot VIX. Prior to expiration, however, the appropriate underlying to focus on is the VIX futures. With the VIX currently at about 18 and the VIX futures for the middle of 2011 approximately 50% higher at 27, the VIX futures term structure actually reflects a different underlying for each month of VIX options and futures.

The graphic below summarizes some of the consequences of the steep VIX futures term structure for VIX options. By means of illustration, note that the VIX December 18 puts can be bought for 0.85. The same puts in for March, April or May 2011, however, can be purchased for less than half that price, as I noted yesterday. The explanation is simple: when investors expect the VIX to be at 27, the VIX 18 puts are going to be a lot cheaper than when the VIX is at 18.

For comparison purposes, refer to a similar VIX put matrix from April 2009 that appeared in Selling VIX Puts with the Help of a VIX Put Matrix. At that time, stocks had formed a major bottom the previous month and the consensus expectation was that volatility would be on the decline. For this reason, with the VIX at 34.82, any puts that were “in the money” (in terms of the cash/spot VIX, not vis-à-vis the VIX futures) were more expensive the farther one goes out in time.

With VIX options, the key ingredients are almost always the VIX futures term structure and what it implies about mean reversion expectations.

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Disclosure(s): neutral position in VIX via options at time of writing

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