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Ananthan Thangavel
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Ananthan Thangavel is the Managing Director of Lakshmi Capital and Lead Writer for the RealFinance Commodity Analyst Newsletter. He is particularly proud of producing a return 35.01% annualized since inception (through 12/31/11) for his Lakshmi Capital Global Macro ARS clients... More
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  • Time to Short the January VIX Futures 4 comments
    Sep 27, 2010 1:31 PM | about stocks: VIXX, VXZ
     We have commented in the past on our preference to short volatility and express long positions on stocks by selling put options.  We executed this strategy with great success during the pullbacks of June and August.  However, there remains a potentially extremely profitable trade within the short volatility space.

    Shown below is a chart of the January VIX futures contract.

     

    As of today, the January VIX futures contract is trading at 30.15, down 15 cents on the day.  Take note that this contract is trading down -.5% on a day when it’s underlying index is trading up +4.1%.  Why is this the case?

    The VIX is a mean-reverting index, meaning its’ protracted moves in either direction are likely to revert to their base at some point.  The fundamental reason for this is that the VIX measures the amount investors are willing to pay for insurance (specifically the implied volatility of the S&P 500 option contracts, with a heavy skew towards put options).  During times of great uncertainty or panic such as 9/11, the financial crisis, or the “flash crash” earlier this year, investors greatly increase the amount they are willing to pay to insure their stock portfolios.  However, as time passes and the psychological shock of the event dissipates, the VIX tends to drift downwards again as sellers of these insurance contracts are willing to accept less and less until the index reaches a level near to where it traded before the event.

    As a result of this mean-reverting behavior, the relationship between options and futures on the VIX does not behave as it does for any other commodity, currency or stock.  VIX futures and options almost always trade at a heavy discount or premium to the underlying VIX index.

    Currently, the VIX index is at 22.60.  At this level, the January VIX contract represents a 33.4% premium to the underlying VIX index.  This means that traders’ expectations for volatility in the future are tremendously higher than our current level.  While this can be taken as an ominous sign, it is worth noting that VIX futures for 3-6 months out have traded at heavy premiums to the VIX index ever since the rally starting in March 2009 began.  Simply put, there are many more buyers of volatility than there are sellers.

    Our recommendation is to short the January VIX futures contract.  We believe that the current dislocation represents an enormous opportunity.  In order to turn a loss by selling a January VIX futures contract, the VIX index must by 33.4% higher upon expiration on January 18, 2011.  To illustrate the unlikelihood of that event, we have prepared the following chart of the VIX index over the past 10 years.

    As can be seen from the chart, the 30 level on the VIX index has only been achieved and sustained rarely over the course of the past 10 years.  During the 2000-2002 bear market, the VIX index flirted with this level before skyrocketing above it after 9/11.  Between 2002-2003 the index was also above 30 for much of the remainder of the bear market, which witnessed aggressive selling of equities before bottoming in late 2002.  Between 2007-2009, the VIX witnessed an incredible spike due to the financial crisis.  The most recent spike above 30 occurred in May 2010, directly after the “flash crash” incident.

    After each one of these shocks, the VIX witnessed a precipitous fall, mainly due to the mean-reversion nature of the index.  As we believe the summer correction was only a pullback in the context of a broader bull market, the January VIX futures are grossly overpriced.  In order for the VIX index to be above 30 upon expiration, a significant exogenous shock to the stock market would be necessary, and even if this shock is witnessed, it would need to be timed almost exactly at expiration due to the likelihood of the index falling as quickly as it rose.  Even if one believes that our current pullback is the beginning of a bear market, the magnitude of the decline in equities would need to be quite violent in order to sustain a level above 30 on the VIX.



    Disclosure: Short VIX January Futures
    Stocks: VIXX, VXZ
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Comments (4)
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  • vix switch trader
    , contributor
    Comments (8) | Send Message
     
    lol..i hope you have long feb's or some other hedge because on a spot vix move to 28 those futures will be in the 36 range. in any case, you will not see meaningful convergence til mid to late december if jan's still are at a premium. i would never ever be naked a vix future; just my 2 cents as a vix futures trader.
    2 Oct 2010, 10:15 AM Reply Like
  • Ananthan Thangavel
    , contributor
    Comments (828) | Send Message
     
    Author’s reply » Thanks for you comment, although I believe it was a bit hasty in its formation. Unfortunately actual data does not confirm your opinion.

     

    Taking a beta calculation of the January VIX futures contract vs. the VIX index from June 1, 2010 (when the January contract started trading) until today shows that the VIX futures have a value beta of .192 to the index. This means that a 1 point move in the index has historically yielded a .192 move in the futures contract.

     

    Currently the VIX is at 24.33, and the January contract is at 30.95. If the VIX moved to 28 (a 3.67 point move), we could expect the January futures contract to trade up by .7 point, meaning the January contract would move to the 32 range, not the 36 range you specified. This makes sense considering how huge a premium the futures contract is already trading to the index.

     

    Buying the VIX futures contract here is a wildly speculative bet, considering that you not only need the VIX to go above 30, but stay there until expiration. Sustaining a move above 30 on the VIX would take a renewed secular bear market, and a particularly violent one to warrant institutional investors consistently paying such a historically high price for put protection. Feel free to buy the futures contract here and pray for the 27% premium to somehow be underpriced. I will be the one selling them to you.
    4 Oct 2010, 12:21 PM Reply Like
  • vix switch trader
    , contributor
    Comments (8) | Send Message
     
    true, i was hasty. it is rare i see someone in my turf. you are correct on the surface regarding delta, etc; all i am speaking against is being naked the short. consider going long in feb or mar. sure you have been selling to me; that is correct but i'll put my earnings against your's any time.
    4 Oct 2010, 01:15 PM Reply Like
  • Ananthan Thangavel
    , contributor
    Comments (828) | Send Message
     
    Author’s reply » The VIX futures and options space is a rarely discussed area, I appreciate someone else with knowledge of the product commenting. It is true that a naked short position on the VIX futures carries risk inherent to an unhedged short position, but the point of my article is to point out the risk/reward relationship of putting on such a trade due to the margin of safety built in to the futures premium.

     

    Regarding my performance, I regularly publish my statistics on my website: lakshmicapitalmgmt.com.... I am quite happy with posting a 26.86% return year-to-date and hope to continue generating value for my clients.
    4 Oct 2010, 02:14 PM Reply Like
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