Tuesday, February 26, 2008

Do Reliable Oscillations In The VIX Make VIX Options An Easy Profit Vehicle?

Ive seen some articles in the press over the last few months suggesting that one way to profit in volatile markets is by trading VIX options. They typically make it sound easy. You dont even need to know the direction of the market. You just need to determine whether volatility is likely to rise or fall. If you think volatility is going higher, you can buy VIX call options. If you think its going lower you can buy VIX put options. The problem with this logic is that VIX option prices do not follow the VIX index. They follow VIX futures prices. A couple of months ago I decided to quantify how much this really matters.

It is well known by traders that the VIX has a strong tendency to oscillate. Therefore, when people consider trading the VIX, they many times think mean-reverting strategies will work best. I took some simple mean-reverting strategies and applied them to the index to see what kind of returns I would get. Two examples were: 1) Short the VIX if it closes 15% or more above its 10-day moving average. Cover when it closes below its 10-day moving average. 2) Short the VIX if it closes at a 10-day high. Cover when it closes below its 10-day moving average. In both cases the opposite stretch would apply for purchases. Not surprisingly, they worked. What was intriguing was HOW WELL they worked. I then combined these strategies with a few others to create an indicator which would signal to me when the VIX was stretched and due for a reversal.

Assuming you treated the VIX as a security and allocated a certain dollar amount whenever you bought/shorted it, over the last 3 years my simple system would have returned about 170% per year based on raw returns (no commissions or slippage).

Now, to see the effect that trading futures would have on the system, I downloaded all the historical data from CBOE and ran the trades through using front month options. I performed rollovers those times when the future expired before the trade closed. Note that the entry and exit triggers were based on the action in the VIX not in the futures. The purpose of the study was to see whether someone could trade futures/options based on the action in the VIX index. The results? Instead of returning 170%/yr over the last 3 years, the system now returned 5% total. Factor in some commissions and slippage and my incredible system is now a money-loser.

Moral of the story: Be careful when trading VIX options / futures. Simple systems which look spectacular on the VIX cash index simply do not translate.

Below are some informative links which also discuss this issue.