Thursday, July 22, 2010

Volatility arb

There is a large contango in VIX futures. I'm arbing it by shorting Aug VIX and buying Sept SPY puts (since the Aug VIX is supposed to reflect the IVs of Sept options) at various strikes w/ IVs at around 22-24%. Over next week or 2, assuming the market doesn't move, Aug VIX should converge down to VIX index, while IVs on SPY options increase as they near expiration. If market moves up or down, the two sides of the pair offset each other. In fact, on the face of it, it appears that the net paired trade is long gamma, meaning that the pair together makes money the further the market moves away from the original price upon entry, assuming both sides of the trade were delta-hedged at the beginning (you will have to come up with an approximation for the delta of Aug VIX). This may lead one to want to sell calls on VIX instead of outright shorting it if you want to neutralize gamma. However, a short VIX position itself may be slightly negative gamma already, as there's a built-in floor to VIX as the market moves up, while VIX can scream much higher as the market falters. Thus, I think an outright short on VIX is adequate.

Alternatively, you short the VXX ETN, which is comprised of both Aug and Sept VIX futures, and buy corresponding weights of Sept and Oct SPY puts. As of July 22, the VXX fund has mostly Aug futures and is dumping some every day to buy Sept futures. In fact, this may be preferable, as people are always trying to front-run these cumbersome ETFs/ETNs.