Suppose the recent death spiral in the CBOE S&P 500 Volatility Index (CBOE:VIX) to fresh multi-year lows has your inner contrarian vying for some type of bullish play. You might contend the risk-reward favors such a bet. With the VIX hovering in the 15 zone, the downside appears quite small and the upside quite large.
The problem — which any curious spectator inevitably encounters when they attempt to implement an idea of this sort — is the realization that you can’t simply buy and sell shares of the VIX. It’s merely a quirky statistical index that is subject to a number of day-to-day anomalies.
Traders determined to make some type of related bet on the VIX are relegated to trading VIX futures, VIX options based on VIX futures, or ETNs based on VIX futures (e.g. VXX, TVIX, VXZ, etc.). Yet another route consists of structuring some type of long or short volatility strategy, such as straddles, using options on the S&P 500 Index (SPX) options directly.
In assessing the current status of VIX futures (shown below), a few key points become apparent.
1. Not a single VIX future is anywhere close to the current value of the VIX index. Obviously the March futures are closest at $17.65, but they are still trading at a $2.50 premium and have a mere five trading days remaining, leaving little time to exploit any sizable rise in the VIX.
2. The term structure of the VIX futures is strongly upward sloping (otherwise known as contango), where each month is trading at higher levels than the prior month.
Given that a rise in the VIX is already baked in the cake, it is quite difficult to structure bullish VIX option plays to take advantage of the low level of the VIX Index. Suppose you were looking to sell at-the-money puts to exploit a rising VIX in the coming months. Take a look at how much premium is available in the 16 strike puts across the different expiration months:
- March 16 put: 25 cents
- April 16 put: 25 cents
- May 16 put: 15 cents
- June 16 put: 15 cents
Notice a recurring theme? There’s simply no premium available. This is due to the fact that later-dated VIX futures are already trading at such lofty levels relative to the VIX Index.
Here’s the bottom line: structuring bullish plays on the VIX Index is much more complex than meets the eye. And it’s especially difficult when the VIX futures are in steep contango.
At the time of this writing, Tyler Craig owned short positions on VXX.