How To Trade Volatility With Mark Sebastian

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. 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:

Trading with volatility products such as VIX, VIX Futures, VXX, and UVXY. Download the FREE VIX ebook here.

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.