So I saw this question go by on Twitter:
Yes, we can trade VIX futures and options on VIX futures. And derivatives like the iPath S&P 500 VIX Short-Term Futures (NYSE: VXX) and the iPath S&P 500 VIX Mid-Term Futures (NYSE: VXZ) that are ETN’s but more or less base off VIX futures. We can even trade inverse VIX ETN’s like VelocityShares Daily Inverse VIX Short Term (NYSE: XIV), and combos of all the above like UBS AG Exchange Traded Access Securities Daily Long-Short VIX (NYSE: XVIX).
Yet no actual VIX ETN or ETF that track’s the “spot” price you see on the board.
Well, VIX is simply a statistic, it’s a standard deviation proxy. It’s calculated based on the implied volatility of actual S&P 500 Index Options (CBOE: SPX). Implied volatility is merely one variable that goes into the pricing of those SPX options, the others are the price of the underlying, the strike price, the cost of carry (dividends and interest) and the time until expiration. What separates implied volatility is that it fluctuates, whereas the other variables are “fixed”. At least in theory.
In reality, time until expiration is NOT fixed, at least in the manner in which traders price time. Not all time is equal. For example, the four days between today (Monday) and Friday do not equal the four days between this coming Friday and the following Tuesday. The market’s open between now and Friday and stocks figure to move, whereas from Friday going forward the market has one likely-slow, pre-holiday session and then three off-days. So clearly I would pay more today for an option that encompasses the next four days than I would on Friday morning for an option that covers four days forward from there.
An SPX trader this Friday will not pay full fare for “time”. He will correctly note that options he buys on Friday will immediately face little or no movement in the underlying for the next 4 calendar days, so thus he will pay less for them. That translates into a lower implied volatility on the options on Friday, and ergo a lower VIX. In reality, volatility has not dipped, he’s simply pricing out the weekend time decay. Fast forward to Monday and the actual price of the SPX options has not declined as much as “normal” for four days, simply because they already reflected a later date in the calendar. This has the effect of lifting a volatility calculation such as VIX back up, but again, actual volatility assumptions have stayed fairly constant.
If you had an actual spot VIX to trade, you could simply buy the pre-holiday close and sell the post-holiday open and make money virtually every time.
And this is just one known “quirk”. You could also short “spot” VIX into ramps ahead of all news events. Think of a regular stock option before earnings. The implied volatility of the options ramps up, the stock reacts to earnings, and then the implied volatility crashes. But you can’t actually sell the options and make money, because you don’t know how far the stock itself will move.
VIX is a great proxy for market sentiment, but it’s just a number and not tradable on its own.
Follow Adam Warner on Twitter @agwarner.