Relative Value of VIX

editors note: Mark Sebastian wrote this Friday. We just got it and hope you’ll enjoy it.

One of the first things I teach my options mentoring students, on their way toward a great options education, is to understand how to understand the relative value of VIX.  VIX is not a standalone product; it is a derivative of SPX.  Thus, if one wants to properly read VIX, one must take it in relation to how the SPX is moving.  

For instance, yesterday (Thursday 6/21), I tweeted that based on the lack of movement in the VIX, I think the SPX is primed for a bounce today.  To which I got many a flabbergasted  responses saying “16%” isn’t big?  The answer was no, 16% was not big, not in relation to a 30 point drop in the SPX.  Let’s examine why.

First one must understand what VIX is.  While, it’s not exactly correct mathematically, the VIX is essentially a vega weighted index.  The more vega, the more it counts in the VIX is for sure true.  There are some nuances in that downside puts have a stronger effect on VIX than upside calls, but we do not need to get into the heavy math.

SPY SKEW from Livevol (r)

Be aware that there is something called SKEW.  I talk about it in my book, the CBOE puts and index out, and I have blogged about it many a time.  In the case of the SPX, the skew is backward, or an equity skew.  Essentially, OTM puts have a higher IV than OTM calls.  When we put the idea of VIX’s quasi vega weighting into our head, and we are aware (as all of you are) that ATM options have the most vega, then, as the underlying in the SPX falls, even if the underlying IV’s don’t increase, simply by putting more weighting on the 1325 strike vs. the 1355 strike, it produces a much higher VIX (about 2.85 points to be exact).  I have illustrated the move below:

Livevol (r)

That is why I was commenting on VIX yesterday.  The truth is that a 16% move in VIX can be a huge move…if the SPX doesn’t drop that much.  If we had only been down 15 points yesterday, and the VIX was up by 16% I would call that a massive VIX move.  Moving on to today, the SPX is only up about 12 points as I write this. Yet, the VIX is down 2.15 points.  Is that a big move?  While there might be some weekend effect in there, my answer would be yes.  In fact, looking at the ATM IV from Wed and Friday, we can see that IV, despite a higher VIX, is actually lower now than it was on Wednesday evening AFTER the fed.

1330 strike:

1355 strike:

Livevol (r)

Notice, when one gets granular and looks at strike vols instead of VIX, one gets a much clearer picture of what volatility is actually doing.  This is why all of our option mentoring students track the vols they buy and sell, not just VIX.

The Trade:

With the VIX futures still in a huge contango, and we think we could see a major push higher in SPX and a drop to 16 in VIX.  I like playing that move via the ETN’s VXX or XIV.  I also like the idea of a SPY or SPX fly.