Selling VIX Puts with the Help of a Put Matrix

The VIX was at 51.65 when the SPX formed its “devil’s bottom” at 666.79 almost two months ago. Since then, the SPX has gone up almost exactly one third and the VIX has dropped almost exactly one third. As the SPX continues to rise – recently breaking through an important resistance level at 875 – the VIX seems somewhat reluctant to continue lower. This is consistent with my statement of two weeks ago that “my personal forecast is for the recent decline in volatility to drop to no lower than the 30-32 level before flattening out.”

A floor in volatility does not necessarily mean that the VIX is destined to spike back up toward 50. It does, however, mean that some interesting VIX options trade may present themselves. For instance, if you believe that the VIX is not likely to stay below 35, you can sell a VIX put and capture a fair amount of premium with little downside risk. While ‘little’ is a subjective term, VIX puts are less risky than other naked puts because while volatility has a tendency to spike up, the path down (except from upward spikes) is almost always a gradual one.

With this in mind, I want to highlight an options matrix feature that optionsXpress has on their site. Customers can create either a call or put matrix for any optionable security and view the bid and ask prices over the next six months in a matrix format. The graphic below shows VIX puts from May to October at all strikes from 10 to 100.

If you study the chart, you can see a great deal of interesting information. Regarding the possibility of a VIX put floor, you can see it priced in. VIX May 35 puts can be sold for 1.90 at the moment, while the June 35s fetch 2.75. Going out further in time, however, yields very little in the way of incremental premium. The July 35s are bid at 3.10, the August 35s at 3.30, the September 35s at 3.40, etc.

For some additional fun, check out the bids for the 60 puts. They are almost identical for each month from May through October. Why? Part of the answer is that mean reversion is built into the options prices.

VIX options have some interesting quirks that take awhile for most investors to internalize. By looking at a put matrix or call matrix, however, it is much easier to get a sense of what types of future VIX moves are built into VIX options prices.

[source: optionsXpress]

Disclosure: Long VIX at time of writing.

Commercial Real Estate Blogs

Since I have been beating the commercial real estate drum for the past week or so and plan to move on to other topics, I think it is only appropriate to pay homage to some of the blogs that tackle CRE on a full-time basis.

Frankly, the pickings are slimmer when it comes to commercial real estate blogs than residential real estate blogs, but there are still quite a few excellent sources of information. Three of my favorites are Deal Junkie, Llenrock and Real Property Alpha.

A broader list of some commercial real estate blogs worth checking out includes the following:

• Deal Junkie
• Llenrock
• Real Property Alpha
• Street Wise
• CRE Review
• Deal Book
• Places Magazine
• Retail Traffic
• Trend Czar
• Square Feet
• From the Inside
• The Ground Floor
• Counter Culture
• Brokered

Three Commercial Real Estate Sub-Sector ETFs to Watch

I plead guilty to treating commercial real estate as a single homogeneous entity in my two previous commercial real estate posts, Commercial Real Estate Problems Piling Up and Moodys/REAL Commercial Property Price Index.

The truth is that while there are a wide variety of REITs out there that span the full range of commercial real estate activity, my focus is mainly on ETFs and when it comes to ETFs, most of the popular real estate ETFs are of the large catchall variety, such as IYR, ICF, VNQ and RWR.

While I am not aware of any ETFs that are pure plays on shopping center REITs, office REITs or apartment REITs, there are three commercial real estate sub-sector REIT ETFs that can help sort through various sectoral trends within the REIT universe. The three sub-sector ETFs, with their allocations as of April 28^th are as follows:

FTSE NAREIT Retail Capped Index Fund (RTL)

• 52.28% Equity Shopping Centers
• 35.85% Equity Regional Malls
• 11.47% Equity Free Standing
• 0.20% Short-Term Securities
  

FTSE NAREIT Industrial/Office Capped Index Fund (FIO)

• 54.87% Equity Office
• 26.92% Equity Industrial
• 17.93% Equity Mixed
  

FTSE NAREIT Residential Plus Capped Index Fund (REZ)

• 41.98% Equity Apartments
• 39.02% Equity Health Care
• 15.35% Equity Self Storage
• 3.37% Equity Manufactured Homes
• 0.07% Short-Term Securities
  

For the record, the limited liquidity for RTL and FIO makes them better indicators than trading vehicles, but REZ is actively traded.

As the chart below shows, the retail and industrial/office REIT ETFs have moved almost in lockstep in the post-Lehman world, while the residential ETF fared better in the downturn, but has been a little more sluggish during the bounce off of the March bottom.

[source: StockCharts.com]

Moodys/REAL Commercial Property Price Index

Last week, in Commercial Real Estate Problems Piling Up, I opined that commercial real estate is a likely candidate to usher in the next leg of the financial crisis. Since the S&P/Case-Shiller Home Price Index gets so much publicity, I thought this would be a good opportunity to mention a commercial real estate index that deserves more attention: the Moodys/REAL Commercial Property Price Index.

This index was last updated April 24^th and shows that prices have dropped slightly more than 20% since the October 2007 peak.

While residential prices are important to watch, most of the residential story has already been told. The rest of the real estate story – good or bad – likely lies on the commercial side.

[source: MIT Center for Real Estate, Real Capital Analytics]

HOGS Gets Slaughtered

I am far from being an expert on swine flu, but based on everything I have heard, there is no evidence to support that swine flu can be transmitted through the consumption of pork products. Still, investors did not let this fact stand in the way of selling Zhongpin (HOGS), the $231 million (market cap) Chinese producer of pork and pork products. HOGS fell 6.2% yesterday on the second highest volume session since last July in what was clearly a case of guilt by association.

Options traders, however, reacted in a different fashion. The graphic below, courtesy of WhatsTrading.com, shows that while options activity spiked dramatically, most of the action was in calls, which was running at about twice the rate of put volume yesterday. Also, implied volatility (not shown) more than doubled.

Obviously there is a great deal of uncertainty surrounding swine flu – and a fair amount of misinformation being circulated. There is no doubt that eating pork products is unrelated to the spread of swine flu, but that does not necessarily mean that pork products and stocks such as Zhongpin will be shunned and suffer real declines.

[source: WhatsTrading.com]

Disclosure: Long HOGS at time of writing.

Chart of the Week: Continuing Jobless Claims

With all the hoopla over some of the green sprouts that are appearing in the economic garden and the knowledge that it has been four weeks since initial jobless claims peaked at a level just below the October 1982 record, I wanted to provide a picture of continuing jobless claims that is very different from the more widely reported initial claims data.

The chart of the week below tracks continuing jobless claims since 1967. Whereas initial jobless claims (red line) are currently just below the 1982 record levels, continuing claims (blue line) have spiked to levels that dwarf 1982 levels by more than 30%.

Initial jobless claims are indeed an important concern, but right now the bigger problem is that existing jobless workers are having an extremely difficult time finding new work. Unfortunately, after setting new records for 12 weeks in a row, the trend in continuing claims shows no sign of letting up at this time.

[source: Department of Labor]

XLY and XHB Move Above 200 Day Moving Averages

Two important ETFs, XLY (consumer discretionary) and XHB (homebuilders) have moved above their 200 day simple moving averages today for the first time since early October.

Among other important indices and ETFs that are closing in on their 200 day SMAs are the NASDAQ-100 index (NDX), semiconductor index (SOX) and emerging markets ETF (EEM).

If the current bullishness holds, we may see widespread moves above the 200 day SMA – and the possibility of renewed buying interest…or an opportunity to take profits.

I am cautious as the SPX approaches 875, but am not interested in a substantial short position until there is some sort of bearish momentum.

The New VIX Macro Cycle Picture

Since the dawn of VIX data, which extends back to 1990, the VIX has shown a tendency to move in cycles of 2-4 years that I refer to as VIX macro cycles.

The chart below shows six distinct VIX macro cycle periods of declining, rising or flat volatility. For now I have assigned a letter to each period, but at some point I may go back and name each of them, describe the various influences on volatility during the period and set about establishing a fundamental and technical basis for classification.

My goals for today are much more modest. For the moment I am establishing January 2007 to November 2008 as the official endpoints of the most recent period of rising volatility. As of December, we are in a new VIX macro cycle. While the first few months of this new volatility era showed a dramatic decline in volatility, I suspect that volatility will flatten out relatively soon, as was the case when the volatility spikes of 1994 and 1998 ushered in a period of relatively flat volatility.

Note from past volatility spikes that the initial snap back to lower levels of volatility typically last from 4-6 months after peak volatility. If this pattern were to be repeated once again, then I would expect volatility to put in a new bottom in no more than the next 2-3 weeks.

Guessing where volatility will find a new plateau is not easy, but for now I am establishing a provisional bottom of 30. Ultimately, I would not be surprised if I move the bottom down to somewhere in the 25-27 range, but there is a lot of work to be done before that much fear and volatility can be driven from the collective investor psyche and markets are able to establish a degree of comfort with the various financial and economic institutions that will shape the major events and policies of the next few years.

[source: StockCharts]

How to Create Your Own Portable VXV

I recently received a question from a reader who was looking to create a homemade version of the VXV that he could apply to the Nifty (formally known as the S&P CNX Nifty), which is an index of 50 large capitalization companies on the National Stock Exchange of India. Specifically, the reader wanted to know if it would be possible to use a 93 day moving average of the India VIX to create an index that would be analogous to the VXV.

Actually, VXV ignores all historical volatility readings and utilizes implied volatility instead. It is the blending of implied volatility for the options from the months that are closest to 93 days into the future.

Refer to the graphic below and I will create a “quick and dirty” version of VXV that can be used on any underlying that has options. The example here is for the SPX, but the same process can yield a VXV proxy for any underlying.

The steps are as follows:

1. Determine the two options expiration months whose time to expiration is closest to 93 days (the term for the VXV). In this case we are using July, with 85 days until expiration and August, with 120 days until expiration. Of course once each month there will be one month with exactly 93 days until expiration.
   
   
2. Determine the last close in the SPX and the series immediately above and below the last close for each of the two months. Here the last close is 843.55. For July, the series for the calculations are 840 and 850. For August, we use 825 and 850.
   
   
3. Determine the implied volatility levels for both the puts and calls for the relevant series for each of the two months. These are highlighted in red in the optionsXpress graphic below.
   
   
4. Interpolate the implied volatility for the SPX close from the two July calls (A), July puts (B), August calls (C) and August puts (D). In this case the interpolation is done by assuming the proportions for the SPX close are the same as they are for the implied volatility values. For example:
   A = 31.1 + (6.45/10)*(31.3-31.1)
   A = 31.229
   
   
5. Now that we have implied volatility levels for the SPX close, we need to average these across both puts and calls for each month. July = (A + B) / 2 and August = (C + D) / 2
   
   
6. Finally, interpolate the July and August results from the step above to estimate 93 day implied volatility. The easiest way to do this is to start with the nearer month and then add the appropriate fractional portion of the later month that lifts the blended average to 93. The approach is analogous to the interpolation above and yields and equation that looks like this:
   VXV = [(A + B) / 2] + [(93-85)/(120-85) * ((C + D) / 2) – ((A + B) / 2)]

This is not the same approach that is used by the CBOE, which is more complex and is detailed in the CBOE S&P 500 3-Month Volatility Index Description. This quick and dirty variant can be calculated quickly and is portable across any underlying with options, including the Nifty.

[source: optionsXpress]

Lost in Translation: VXX and VXZ

Partly based on some thinking I laid out last week in Some VIX Milestones…and a Prediction, I was fortunate to be long VXX, the iPath S&P 500 VIX Short-Term Futures ETN, going into yesterday’s session.

VXX notched a nice one day gain of 7.40%, but this was less than half of the 15.44% gain in the VIX. On the other hand, VXZ, iPath S&P 500 VIX Mid-Term Futures ETN, which targets VIX futures approximately five months out, moved a mere 3.41%, less than half of VXZ. As shown in the chart below, VXZ’s jump did not even match that of the 4.28% drop in the SPX.

All things considered, these are about the percentage moves relative to the VIX that one should expect. I have previously discussed the relative juice factor in VXX Data Now Painting an Accurate Picture and elsewhere, but apparently not everyone has internalized this information yet. Further, if you follow any of the term structure discussions here, the volatility predictions as a function of months into the future is a recurring theme.

With almost three months of data to draw upon, VXX is now averaging close to 50% of the daily move in the VIX and VXZ is averaging approximately 20% of the daily move in the VIX. The bottom line is that if you are looking for the type of moves generated by the cash VIX, your best bets are VIX options, VIX futures or a 2x leveraged play on VXX.

Personally, I find VIX options to generally be the most attractive way to trade the VIX, given their liquidity and the flexibility inherent in structuring a wide range of options positions.

[graphic: VIXandMore]

Disclosure: Long VXX at time of writing.

Commercial Real Estate Problems Piling Up

Though it gets little in the way of airplay on the blog, real estate happens to be one of my favorite asset classes. It is volatile, can be highly leveraged and also provides what I call “use value,” meaning that it is not necessarily just a piece of paper you hope will appreciate, but can also be tangible property that you can get some enjoyment out of. For the same reason, I would much rather have a Miró hanging on my wall than an investment in an art ETF.

Getting back to real estate, I theorized in Waiting for the Next Shoe to Drop that either credit card debt or commercial real estate would be the most likely candidates to usher in the next leg of the financial crisis.

Moody’s recently reported that the U.S. credit card charge-off rate rose to a record 8.82% in February and noted that they expect charge-offs to hit a peak of 10.5% during the first half of 2010.

The ticking bomb of commercial real estate may have even more severe consequences as commercial real estate prices continue down over the course of the next few years. A week ago, Fil Zucchi did an excellent job of explaining the problems in commercial real estate at Minyanville in A Commercial Real Estate Comeback? and today he is back with a follow-up piece, Ten Reasons Why Commercial Real Estate Won’t Rebound.

There are many ways to play real estate. The double ETFs, URE (+2x) and SRS (-2x) are a good place to look for trading vehicles. For non-leveraged plays, IYR offers the best liquidity and an active options market to boot. Given the strength of the recent bounce in real estate stocks (more than 50% off of the recent bottom, as the chart below shows), I would favor the short side at least until I get a better sense of how the commercial real estate story will unfold.

[source: StockCharts]

Disclosure: Short IYR at time of writing.

Chart of the Week: Capacity Utilization Sets New Low

I have been bullish since March 5^th (SPX at 687; Intermediate Bottom Potential Is High), but a number of factors have turned my bias back to the bearish side in the course of the past few days.

Apart from some technical indicators which suggest equities are overbought at present, there has been a recent wave of economic data, much of it swept under the rug, which suggests that bullish headlines may soon be on the wane. The news spans housing starts to foreclosures to credit card charge-offs to retail sales and industrial production. Frankly, none of it looks promising.

Joined at the hip to the industrial production report is capacity utilization data. Essentially, this statistic measures how much of the national production capacity is being used and how much is sitting idle.

This week’s chart of the week looks at the full history of total capacity utilization in the United States, based on data available from the Federal Reserve. Total capacity utilization for March was just 69.3%. This is the lowest number in the history of this statistical series, which dates back to 1967. While not shown in the graph below, manufacturing capacity utilization fell to 65.8%, which is the lowest number since records were first gathered in 1948.

In terms of interpreting the capacity utilization data, it is probably best to think of the number as a broad measure of demand relative to existing infrastructure. Of course the current record low numbers reflect a historic weakness in demand. Capacity utilization is also a strong predictor of inflationary and deflationary pressures. With so much slack in the system, deflationary pressures are sure to increase as prices get slashed in order to offset the high fixed costs of so much idle productive capacity.

In addition to the current bad news, there are some complicating factors which may make it difficult to reverse the recent trend. Looking ahead, a stronger dollar and weaker consumer does not bode well for future production data – and should raise new concerns about the possibility of deflation.

Industrial production may steal most of the headlines, but capacity utilization is an often overlooked important piece of the economic puzzle.

[source: Federal Reserve]

VIX:VXV Ratio Down to 0.92

With the SPX at 873, it looks like a good time to get short to me...

Some VIX Milestones…and a Prediction

It was an interesting trading day not matter how you slice it. When all was said and done the SPX had its highest close since February 9^th and moved as close as it has been to its 200 day simple moving average (SMA) since September 26^th of last year.

The VIX hit some interesting milestones as well. Today’s close of 35.79 was the lowest close since that same September 26^th and the 10 day SMA of the VIX is under 40 (as of yesterday) for the first time since the beginning of October. Elsewhere in the VIX family, the iPath S&P 500 VIX Short-Term Futures ETN, VXX, is now at its lowest level (94.91) since its January 30^th launch. Finally, the 10 day historical volatility in the SPX is at a 10 week low (31.18) and 20 day HV just slid below 40 for the first time in 6 weeks.

While the numbers above represent an incremental change in volatility, they also reflect a sea change in investor outlook. Just a few weeks ago it was widely believed that all the banks were insolvent, the economy was not going to turn around until 2010 and if we were lucky, the housing market might bottom before the end of the year.

A flicker of hope here and a flicker of hope there and now suddenly some of the worst case scenarios are being discarded. Perhaps it is just a case of the slowing pace of economic deterioration, but there is always the possibility that things have already started to turn up. After six months of bad news getting worse and worse news morphing into terrifying, even just being able to set aside a couple of the potential disaster scenarios seems to be cause for celebration. But, are the celebrations premature?

Volatility is notoriously difficult to predict, but my personal forecast is for the recent decline in volatility to drop to no lower than the 30-32 level before flattening out, perhaps just in time to meet the 20 month SMA in the (monthly) chart below.

If you have not looked into or traded VXX, next week might be a good time to think about hedging or speculating on an upside move in volatility with this VIX ETN.

[source: StockCharts]

Straddles vs. Iron Butterflies

After receiving several questions and comments regarding yesterday’s VIX Expiration Straddles and a related prior post, A VIX Butterfly Play, I realize that I skirted a fundamental options issue that I should probably have placed more emphasis on: unlimited vs. limited risk.

The issue centers around a key concept in trading options: is the maximum loss on a position limited? In other words, at the time the position is opened, is it possible to define, in dollar terms, the maximum loss and the price points at which this loss will occur?

The question can also be addressed in graphical form.

In the profit and loss graph below, courtesy of optionsXpress, I have replicated a trade that is similar to the straddle trade highlighted in VIX Expiration Straddles, except that it uses May options.

If the trade has unlimited risk, such as is the case with the short straddle below, the profit and loss graph will show diagonal lines at the extreme left and right side of the x-axis.

By contrast, it is possible to augment a short straddle position by buying insurance to protect against unlimited losses in the form of an equal amount of long calls (known in some circles as “buying the wings.”) The result is an iron butterfly, with the “wings” limiting losses.

The graphic below shows the same trade as the short straddle above, but with the additional purchase of out of the money puts and calls. Notice how the new wings are the horizontal lines that reflect limited losses of $440 in this position.

The wings are particularly important in the event of extreme moves. In the short straddle, every dollar move in the VIX above 45 results in an additional $1000 loss. The iron butterfly, however, limits losses at 40, so the VIX can spike as much as it wishes over 40 without impacting the bottom line. The same dynamics are at work were the VIX to plunge dramatically.

Note also the cost of the insurance will reduce the maximum potential profit (which falls from $5510 to $2060) by 63% and also shrink the price range in which the trade is profitable (from 31.99 – 43.01 to 35.44 – 39.56) by the same 63%.

It may be helpful to think of the cost of buying the wings as the price of insurance to limit risk. Most traders prefer to pay the insurance premium and sleep better at night, but there are those who prefer to forego the wings and hope to avoid a disaster. This type of approach can be effective in the short-term, but over the long haul is an excellent way to lose all your trading capital.

For the record, the same relationship described above with respect to straddles and butterflies is analogous to the relationship between strangles and condors.

[graphics: optionsXpress]