Volatility: KM Is Playing With The Street's (and my) Emotions

Position: Long VXX - this morning (at the market's highs), Keith added a tactical long on near-term equity volatility via the VXX ETF.  This relatively new product tracks a rolling position in the front two month CBOE VIX contracts.

Essentially, the CBOE VIX index is a measure of the volatility IMPLIED by the weighted average of the implied volatilities for a wide range of strikes in the 1st & 2nd expiration months for puts and calls options on the S&P.

The corresponding futures allow traders to take a directional view on broad market volatility at some point in the future.  The settlement price of the futures contract and the VIX become equal on the future contract's expiration date.  This leaves room for divergence between the index level and futures price (known as basis) as the futures markets reflect the anticipated level of options volatility at some point in the future while the index reflects the current price of near term options. 

Admittedly that is confusing, but what it means is the VIX represents the current level of near term volatility while the futures represent what investors think that VIX level will be at a point further out in time.

Volatility: KM Is Playing With The Street's (and my) Emotions  - ab1

 

During the 2008 mother-of-all volatility spikes, the traders in the futures pits held firm at levels that were much closer to historically normal levels (see above chart). The ones that held firm through what was a painful period to be short were rewarded when the VIX did come back to earth, eventually.

Volatility: KM Is Playing With The Street's (and my) Emotions  - ab2

 

We are using the VXX as a proxy for the VIX, which we actually track in our models. Since March, the futures have tracked the index closely, with a correlation of greater than .95 for the front month. As always, we will not use a product as a trading unless we are sure that it can provide the exposure that we are looking for (similar to our USO/OIL and FXI/CAF usage, which changes depending on the investment thesis). In this instance the VXX is getting us close enough to the index for comfort.

Feel free to hit me with any questions.

Andrew Barber
Director