Don Fishback

Beware Potential New VIX Products

Hey Stephen, what you just said about being honest with one's level of sophistication could not be any more perfectly said. If you're not honest with yourself, you'll get destroyed. Maybe not immediately, but eventually.

As far as an alternative volatility play, isn't that the key question?

Here's the unfortunate answer. There is none, at least none that is easily accessible to the retail trader. Want proof. Think about this: If there was a pure play on volatility, don't you think they'd have launched that product by now? Instead, they're launching a product based on the futures. The reason is pretty simple. A product designed to be a pure play on volatility is almost impossible to create. Otherwise, don't you think someone would be offering it by now ... especially right now!!

I'll just tell you what I do. When volatility is this high, I sell in-the-money covered calls, out-of-the-money naked puts (secured by cash) and credit spreads.

-- Don

Proposed VIX ETNS Are Not a Volatility Bet

Thanks for the comments.

To vix switch trader, you're sort of right about that convergence. Convergence happens. In fact it's a must. [Well sort of. You should see how they calculate the settlement values.] But to say "December was priced lower than spot when it was a back month" is not correct. Notice in the top row of the table that when VIX was 17.83, the December futures were nearly 5.00 points higher at 22.72.

As I said in prior posts, the futures tend to have a greater central tendency than the VIX index itself. As you get closer to expiration, correlations go up and you eventually get the convergence you spoke of. But not always.

What is unusual is the *size* of the departure from spot that occurred in October. As the table above shows, at the end of June, July, August, and even as recently as September 10, the difference between VIX and its futures were mere pennies. But after Lehman's bankruptcy, the difference in the futures and the "spot" went haywire, which would have caused the ETNs to go haywire compared to what most people would have expected.

And that's the key. When VIX makes an extreme move -- up or down -- the normal relationship between VIX and the futures breaks down. At the precise time you want profit from an extreme -- either via a hedge or a speculative position -- the product behaves differently than it normally does.

Why that happens is the lack of arbitrage. The VIX futures and VIX itself are extremely difficult to arbitrage. As I hear it, only Susquehanna even tries. There is a formula for the VIX futures' fair value. It's actually not too difficult, but it is extraordinarily tedious. At any rate, you can still figure out what the fair value should be and then compare that to the VIX futures. This process is extremely common with S&P 500 index futures. The thing about VIX futures is that, unlike other index futures, the difference between fair value and the price can get extremely large for extended periods of time due to the inability to arbitrage.

And if you want evidence as to the ease/difficulty of the arbitrage play, think of this. If it was easy to replicate VIX itself, why not launch an ETF that mimicked VIX instead of the futures? How popular do you think THAT would be? I know I'd find it tempting. But there are zero plans to launch a product like that, because nobody can create a portfolio of tradeable securities that consistently replicates VIX itself. If they could, they would ... and then they'd easily arbitrage the futures divergence. The implications of this are: The divergences that exist for weeks at a time are proof that arbitrage doesn't exist in any meaningful size.

Now it is true that the ETN's prospectus mentions arbitrage. But it's important to realize they're talking about the arbitrage between the ETN and the futures contracts, not the ETN and the VIX itself.

One final thing, and this is important regarding convergence. Because these products are perpetual, they may never converge. Unlike futures which have an expiration date and therefore *must* converge to spot, these ETNs represent a "rolling" 30-day futures contract, so there is no guarantee of convergence at expiration, because there is no expiration.

As for the other questions you ask, I simply don't have the answer. And I have to say, I don't want to take the time to investigate until these things prove more valuable than I think they'll be.

-- Don

Beware Potential New VIX Products

Hey ETF Expert, Don here.

Thanks for commenting. Before I answer your questions, I have a couple of questions back to you.

You talk about a 95% correlation between the ETN and the item it is tracking. My question is, "What do you think the item is that ETN actually tracks?"

My second question comes from your question that asks, "What would you suggest as a replacement for a volatility play?" Here's my question, "Do you actually think that the new VIX ETN will always represent a volatility play?"

Look forward to hearing your responses.

And as far as waiting and seeing how it performs, they've already posted the backtested data and disclosed the target benchmark, so we can make a preliminary assessment now.

One a completely different subject besides correlations, benchmarks and tracking, one easy assessment is that if you trade these ETNs, you're an unsecured creditor of Barclays!! Do you want your volatility bet to be dependent on the creditworthiness of a teetering bank?

-- Don