The Monthly Volatility Wave Can Help You Trade VXX And UVXY Options

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Includes: TVIX, UVXY, VXX
by: Scott Murray

For the third mid-year consecutively, Eurozone contagion fears are dominating the headlines, and are the primary source of information for traders, who have already completely forgotten corporate earnings in the first quarter. In fact, the financial entertainment media pundits claimed that earnings would be terrible, and the year on year growth was over 6%. Not that any of them would ever admit to being wrong. There is zero credibility in the financial media, and that is why one should tread cautiously when being exposed to strongly held opinions in that forum.

This resumption of fears that a Greece exit will cause instability in the global financial system or create an unsustainable situation for peripheral countries trying to fund their fiscal requirements, is causing elevated levels in the VIX, and as usual, it is "here to stay", they say.

It is not, but let's look at what I have termed the Volatility Wave, or the natural cycle of volatility caused by the options and futures expirations cycle. At some point we will discuss "max pain" and "pinning", but first let's look at how this cycle works historically.

Data source: Options Volatility Trading, Adam Warner

The two lines demonstrated here represent the average historic VIX end of day data (green) and median historic VIX end of day data (blue) going back to the VIX inception in 1993. There is a marked difference between the two, as the outlier events over the last 12 years or so have dragged up the average data, much like the one expensive home in a neighborhood would pull up the average home value. Thus, the median gives us another important view of the data set.

Day one is the first day after options expiration, and day 25 is the last day before expiration. (I am aware that some cycles are calendar shortened.) What is clearly visible is that the wave peaks in the week before options expiration, tails off at the end, and reaches its nadir in the first week of the new cycle. This makes sense as positions are rolled or renewed as the cycle nears its conclusion, but interestingly, not at the end as may have been believed.

What can we conclude from understanding the cycle? That it is probably a good time to buy options in the first week of the cycle and it's probably a good time to sell them in the third week as implied volatility in the options will be higher. This will generally provide you with historic tailwinds before decay accelerates in the final week.

We can apply this to the VXX and UVXY as well. Puts purchased the first week of the OPEX cycle have triple tailwinds, the first being the volatility wave pattern. Secondly, when the futures underlying these products are in contango, the daily roll from the front month to the next month incurs negative roll yield, eating away at these ETFs/ETNs. Thirdly, as the cycle moves forward, the premium in the futures will erode due to time decay. These factors give put buyers statistical advantages, should there be no exogenous shocks, like Euro bank failures, American political debt debacles, or Japanese tsunami related nuclear plant explosions. These things can throw the cycle off to make it meaningless for a month or a few at a time.

Yet, volatility will eventually return to this pattern. Probably sooner than later. What I will do in the near future is explore the data trends in months within the year, to confirm or debunk perceived heightened volatility in October and May, for example. This research may give additional tools to aid in putting on appropriate trades that enhance the probability of success statistically.

I absolutely welcome constructive commentary.

Disclosure: I am short VXX, UVXY.