Three Theses on Volatility

Following up on our recent post about VIX futures, a reader asked:

"If you want to get short volatility, why not just sell some of those VIX futures here, or maybe a vertical spread of VIX options?  Why mess around with equity indexes at all?"

Good question.  The difference depends on what you mean by “volatility.”  VIX futures are a pure vega play, which is to say that they give you exposure to changes in implied volatility, but that’s it.  A short VIX call vertical will get you both vega and some gamma exposure, but it has to be noted that the gamma you’re dealing with is the rate of change of implied volatility, not of some equity underlying; and similarly, the vega in VIX options is the sensitivity to changes in the implied volatility of implied volatility.   Finally, people normally sell hedged options on equity indexes for an entirely different reason: to get exposure to the differential between what implied volatility forecasts today for some date in the future, and the volatility that is actually realized in price history from now until that date.  Again, this last thesis is one of the views you can express by trading vertical spreads, iron condors, butterflies, etc.

So just to be clear, there are three very different theses being pursued here:

1.  Implied volatility will be lower in the future.  Again, this is the view expressed by shorting VIX futures.  At expiration, the payout will be the value of the contract wherever you sold it, less wherever the VIX is at expiration.

2.  Implied volatility will be less volatile in the future and the implied volatility of implied volatility will be lower in the future.  The daring trader of VIX options is voluntarily entagled in this particular web.  We can’t imagine how or why anyone would have a firm opinion about the future implied volatility of implied volatility, but to each his own.

3.  The realized volatility in some equity underlying will be lower in the future than what implied volatility today says it will be.  This is the view expressed by short gamma, short vega trades like iron condors and vertical spreads.  A lot of academic research has been done documenting the risk premium inherent in most equity index options, such that the majority of the time there is a kind of arbitrage opportunity to be had by capturing the difference between implied and realized volatility.

If you want a fourth thesis to consider, Adam over at Daily Options Report discusses a VIX Nov/Dec call diagonal that went off in large size yesterday.  Given all of the above, would it be a crass understatement to say that any trade involving the VIX or volatility isn’t as straightforward as it might seem?

You know what financial product we really, desperately need in this humdrum world of ours?  Variance swaps on VIX options.  They could even form the basis for a new CBOE product, $VIXVIX.  And as the economy collapses around our ears, and we begin a civil war between the pro-American Americans and the terrorist Americans, at least traders and journalists will be able to get a facile glance at “the fear index of the fear index.”

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