This morning, I wrote a
, posted by Chris Kimble on Stocktwits, which made the rounds over
the weekend. This chart showed that, over past decade, many of the
significant market turns, including the two major cyclical bull and
bear markets, commenced within 10 days of the autumnal or vernal
equinox. I'm not too big on seasonal trading patterns, but the
visual impact of this chart is fairly arresting; it is something to
keep in mind as we head into October, which is typically volatile.
Before we get into ways to play or protect against an increase in
volatility, it's important to define what we mean by that term. The
(INDEXCBOE:VIX) is the most widely used gauge of market volatility.
It is a measure of the 30-day options on the
(INDEXSP:.INX). An increase in the VIX, or implied volatility of
SPX options, is typically associated with a decline in the market
as investors bid up the price of put options to protect their
portfolio. And while this is usually true in practice, it is not
accurate regarding the definition of volatility. Volatility, both
realized and implied, is not directional. It is the measure of
realized or expected (implied) market moves, up or down, in a given
As you can see from the chart below, the VIX did indeed spike
during market sell-offs, particularly during the 2008-2009
financial crisis. But note that it also trended higher from
1995-2000, even as the S&P 500 enjoyed an historic bull run
fueled by the dot-com euphoria. During that period, many people
were actually fearful of missing the upside and therefore were
bidding up the price of call options.
On the surface, it seems fairly logical and straightforward to use
VIX-related products (note that you cannot buy the actually VIX as
it is just a mathematical index), such as futures, exchange-traded
notes (like the
iPath S&P 500 VIX Short Term Futures
(NYSEARCA:VXX)), and all the related options if one is expecting a
market decline. But it is crucial to understand that the VIX itself
is mean reverting, and the related products are priced off of
futures, which ultimately must converge. The VIX futures typically
have a forward skew in which the later dates carry a premium. The
result is that the VXX, and other such products, have a downward
bias and theoretically will approach zero over time.
Add to this headwind the fact that the VIX family doesn't always
respond in unison or as expected to market moves. In
a recent article
, Adam Warner, an expert in all things VIX, provides a mouthful of
an explanation as to why volatility-based products, such as the
VXX, are difficult to trade or use as hedges:
The VIX itself has something like a negative 0.60 to negative
0.65 correlation to the S&P 500 Index. In English, that means
it catches a shade under two-thirds of the inverse of the market.
So at best, we're going to see some discrepancies about one-third
of the time. VXX tracks about half the move in the VIX in a given
day, but there are variables there, too. VIX futures don't always
move in tandem with VIX itself. So there is a wide range of
possible relative reactions. Remember always, the VXX is a
normalized VIX future, which is a derivative of VIX, which proxies
the volatility of SPX options, which are derivatives themselves.
That's a long game of telephone when you try to relate the movement
in one end to the movement at the other end.
I'm not trying to dissuade you from using the VIX as a means of
trading or hedging against volatility; I am just suggesting that
you understand the nuances of this asset class. That said, one of
the main advantages of buying the VXX versus put options on the SPX
SPDR S&P 500 ETF Trust
(NYSEARCA:SPY) is that you are not anchored to a specific price
level of the underlying index. This means that implied volatility
will pretty much pop the same amount if the S&P 500 were to
tumble 5% in a two-day period from the 1600 level as it would from
the 1700 level. If you were to buy puts and the market climbed for
a few weeks, those puts would move out of the money and have a much
lower delta if the index declined from a higher price, thus
providing less protection.
The Back Spread
Let's look at one my go-to strategies for bracing for a sharp
. A back spread consists of selling near-the-money options and
buying a greater number of out-of-the-money options, typically with
the same expiration date. For example, with the SPY trading at
$170, one could:
- Sell one October $168 put for $1.50 per contract.
- Buy two October $165 puts for $0.70 per contract.
This 1x2 spread would therefore be done for a $.10 net credit. The
sale of the higher price put finances the purchases of the lower
strike. In that sense, it offsets the impact of time decay. This
means that if the SPY is above $168, both options will expire
worthless and you will collect that $.10 of premium.
But this position is really about capitalizing on a sharp market
decline. Let's break down how it works. The position starts with a
delta of -0.12 or the equivalent of being short 120 shares. But it
, which means that, as the underlying SPY price declines, delta
becomes more negative and the position becomes more bearish or
shorter. It will also benefit from the rise in volatility that
should accompany a steep decline.
This strategy can be tweaked by adjusting the ratio and the width
between strike prices. One of my favored approaches is to sell
later-dated near-the-money puts and then purchase a much greater
number of near-term slightly further out-of-the-money puts.
For example, one could start with selling the October $168 put in
the above example then buy three $167 puts that expire on October
11 for $.50 each. This is an even money position (no cost), but
because the ratio is greater and the width between strikes is
narrower, it has a higher delta and gamma. The options with the
closer expiration dates will also see a larger spike in implied
volatility should there be a sell-off. The trade-off is that the
later-dated options will not decay as quickly, so there is theta
risk. That makes timing, not just market direction, crucial.