OAP 068: VIX Index – How To Trade Volatility w/ Mark Sebastian from OptionPit.com

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Naturally, if you’ve started trading options for any reasonable amount of time you’ll run across the VIX index. Or as it’s commonly referred to, the “Fear” Index. And while the concept of tracking and trading volatility with the VIX might sound intimidating at first, trust me, it’s not all that complicated and just requires a little common sense.

In today’s podcast, we’ve brought on a very special guest, Mark Sebastian, a former floor trader, hedge fund manager and the guy behind OptionPit.com. What’s great about Mark is that not only does he have a lot of experience as an options trader, but he’s also got a lot of specialized knowledge when it comes to the VIX and volatility products like VXX, UVXY, and VXZ that I know you’re going to love.

During the show, we’ll talk about the history of the VIX, how the index is priced, how the VIX futures term structure accounts for mean reversion and some simple strategies you can use to trade volatility with a higher probability of success. So, don’t be afraid to dig into this podcast this Halloween - Mark and I have some yummy volatility treats waiting for you (okay I just had to throw that in there given the release date).

About Mark Sebastian:

  • Mark Sebastian received his Bachelor’s in Science from Villanova University and is a former member of both the Chicago Board Options Exchange and the American Stock Exchange.
  • He is the founder of Option Pit and has specialized experience with the volatility products such as the VIX, VIX Futures, VXX, and UVXY.
  • Mark also runs a hedge fund called Karman Line Capital, that almost exclusively trades VIX and S&P 500 options.
  • He is the author of The Fear Gauge, an eBook describing how the VIX is structured, the history of VIX, and how you can look at the futures term structure and trade the ETPs around the VIX and volatility.
  • He has regularly been featured on CNBC, Fox Business News, Bloomberg, First Business News and is published nationally on Yahoo Finance.
  • Mark is also a contributor for TheStreet.com’s Option Profits Team and is the co-host on the popular Option Block Podcast and Volatility Views Podcast.

Focus of Interview:

Interview Take-Aways:

  • The VIX started out as a volatility-based index and was designed to get an index on where volatility was on the most active index contract at the time, the S&P 100 or the OEX.
  • VIX Futures are a forward contract based on VIX, not an actual contract on the VIX index.
  • These VIX have an underlying tendency to mean revert and the VIX Future is a European-style contract so there is no early exercise.
  • When the VIX is really low, there is an expectation that VIX is going to revert higher; when VIX is very high there is an expectation that it is going to revert lower.
  • Contango refers to a situation where the future spot price is below the current price. This occurs when VIX is low and is likely to revert higher, causing the VIX Future to trade at a premium; buying high and selling low.
  • During times when the VIX is stressed and is very high, the expectation is that it is going to revert lower, thus the VIX Future will trade at a discount.
  • Because there is no early exercise, the VIX is going to follow but not track the cash index.
  • The closer to expiration, the closer it will track the VIX contract. The further out, the lower the volatility of the contract and the greater the deviation from the cash index.
  • VXX is structured to constantly try to keep a duration of the VIX Future at 30 days.
  • On an intra-day basis, VXX will track a 30-day future and does exactly what you'd expect. However, because of the rebalancing of the contract VXX loses money because it buys futures for a greater price than it ends up selling them out at.
  • VIX is 100% driven by the movement in VIX Futures. On a week-to-week and month-to-month basis, VXX is entirely driven by the structure of the VIX curve.
  • Using the VXX as a long-term portfolio hedge is a huge mistake. For a hedge strategy, rather use VIX futures or options over any of the ETPs.
  • XIV is an inverse of VXX. However being short VXX makes more money than being long XIV because XIV has a daily tracking component that can break.
  • Because of the daily tracking component, you can short XIV and short VXX and take advantage of the differential to still make money, even though they are inverses of each other.
  • VIX explodes higher and eases lower. This demonstrates how volatility can expand quickly, but contracts at a slower pace, which means that you do not have to buy a lot of contracts to hedge.
  • VIX allows for less rebalancing and it works in events where things explode.
  • If the front month VIX future trades over the second month VIX future, and the second month starts trading over the third month, and the third month goes over the fourth, this is a sign of an extended increase in volatility.

Question 1: Does volatility make a big move after being low for a long period?

  • Volatility correlates to itself far better than stock price does. When volatility is low, it can stay low longer and go lower than you can imagine.
  • What you have to really look for are changes. Typically, look for several days of the S&P 500 rallying and VIX either rallying or not selling off with it.
  • This is usually a sign of traders buying protection on the way up, which could be a sign of a near term reversal.

Question 2: Most math involved in options pricing and probability calculations seems to involve normal distribution. But obviously, the VIX seems to be a little more skewed in distribution. Is there any way to really take advantage of this differential?

  • There are all sorts of term structure trades. For example, if the VIX cash index is at $12.93, and the VIX future is at $15.10, if you buy the puts for $0.30.
  • If the VIX does nothing or rallies as much as $0.75, you will do break-even or better by expiration.
  • These mean reversion type plays or plays on volatility converging to itself are key.

Question 3: "VXX is a dangerous trimeric creature. It is structured like a bond, trades like a stock, follows VIX futures, and decays like an option.” Given this quote and financial instruments of this type, how can options traders profit consistently from trading VXX?

  • From an options trader standpoint, with VXX, understanding how it is structured is key.
  • With UVXY there is more edge on owning puts that are out of the money than selling calls. This is a product where, because of the natural drift, it maybe makes sense to go from that direction.
  • That being said, when you get a pop, flip around the one by two, buy one and sell two. You can also use it to create put spreads or long debits spreads.
  • Generally, there is more money to be made selling puts.

Question 4: What are prices based on for each of the underlying's and why would anyone trade options on them as a hedge when the futures are much cleaner with no market maker hassle with them? Why trade the options versus the futures?

  • Futures have their own issues in terms of decay, whereas the options allow you to set where your hedge is and the hedge can be cheaper.
  • For instance, back-spreads is a huge institutional trade and is a far cheaper hedge than paying the huge contango cost of owning a future. If you trade directly in the futures and you are using it to hedge, there is a lot of role management that needs to be done.
  • If you want to use futures, they are great but you are basically trading them like corn and wheat. The position management is quite active and intense.
  • From a cost perspective, it can be cheap and if you have an understanding of VVIX, there can be some opportunities to put the volatility of volatility behind your back, on top of taking advantage of relatively low priced volatility.

Final Key-Points:

  • When you are trading VIX options, you have to be aware that every month has it's own underlying. For example, the underlying for the October contract is the October future, and the underlying.
  • The pricing of time spreads and swaps can be very different. It is entirely possible to trade a long call spread for a credit in VIX, but that does not mean it is a good trade.
  • VIX do not do calendar spreads. For example, the month one futures could be more volatile than the month two futures. So if you do a long calendar, the month one future can blast higher and the month two might not keep up with it.
  • The spread will act a lot more like a future spread than an actual time spread when you do those calendars. You can lose more than the cost of the calendar, which is very different than any other type of calendar.

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Option Trader Q&A w/ Jeremy

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. This week's question comes from Jeremy who asks:

In relation to finding candidates for earnings trades, how would you assess which you should or should not be trading? How would you decide which strategy to use? i.e. whether it is a sell, a straddle, or a strangle.

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • IWM Iron Butterfly (Closing Trade): Exiting this IWM iron butterfly options trade gave us a $1,100+ profit after pinning the stock price one day before expiration at the peak of our spread.
  • CMG Iron Condor (Opening Trade): I just recorded my live trading platform (and real money account) as I walked through the process of entering a new iron condor trade in CMG stock. Inside you'll see me analyze, price and fill the trade in real-time.
  • APC Strangle (Closing Trade): Took about $150 out of this small APC strangle trade even after the stock moved completely against our short call strikes this month. But as always, implied volatility always trumps direction and because IV went down, the value of this spread dropped more-so than the impact of the directional move higher.
  • IYR Call Credit Spread (Adjusting Trade): This adjustment is good for 2 reasons. First, it reduces the overall risk in the trade if IYR continues to move higher. Second, it still leaves room for the stock to fall back down into our new profit window.
  • XHB Straddle (Closing Trade): We were able to bank a $120 profit early in the March expiration cycle for our XHB straddle with the stock trading right in the middle of our expected range.
  • AAPL Call Calendar (Opening Trade): Look behind the scenes as I use our new watchlist software to filter quickly and find this AAPL call calendar spread trade during overall low implied volatility in the market.
  • COF Strangle (Adjusting Trade): Here I recorded my live trading screen (and real money account) showing you the entire thought process we used to make an adjustment to my current short strangle in COF to reduce risk.
  • GDX Strangle (Opening Trade): With gold's high IV we are getting into a new strangle with a 70% chance of success and a decent credit for selling option premium.
  • IBB Iron Condor (Closing Trade): Today we're exiting an iron condor we traded in IBB for a $142 profit. Inside you'll see me analyze the exit price and fill the trade in real-time.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.