Corner of Berkshire & Fairfax Message Board

General Category => Investment Ideas => Topic started by: Uccmal on August 09, 2014, 06:01:36 AM

Title: VIX - Volatility Options
Post by: Uccmal on August 09, 2014, 06:01:36 AM
I have noticed that volatility in the big markets is very low right now. 

Some questions: Please No links

1) Does anyone have any experience trading in volatility options?

2) Do these derivatives decay over time? 

3) Do you just buy them in contracts of 100 units like any other derivative?

thanks, Al


Title: Re: VIX - Volatility Options
Post by: RichardGibbons on August 10, 2014, 01:29:40 PM
I did a couple trades in the volatility options, like a decade ago.  So my thoughts might be out of date, but since nobody is responding, I'll try....

The VIX options do decay over time, like any other option.  And they also trade in contracts of 100.  One of the complexities when I looked at them was that they were European exercise, not American exercise.  (i.e. you can only exercise them on expiration day, not before.)

Of course, this has the effect of reducing the value of the longer dated options, and they can trade for less than their intrinsic value.  (e.g. if volatility hits 70 in a crash, your calls with a 20 strike price and 6 months until expiry, are going to be trading for significantly less than 50, because there's a good chance the VIX will be far less than 70 when you can actually exercise the options.)  This is a really important thing, because, unless the option is close to expiration, you'll make much less on calls on a spike in the VIX than you might expect with other (American-style) options.

All that said, for about 15 years, I've been looking for a good way to get long volatility (i.e. something that doesn't require perfect timing and won't decay really fast), and I've never found anything.  I find it much easier to be short volatility.

Title: Re: VIX - Volatility Options
Post by: nnayyar on August 10, 2014, 07:59:50 PM
VIX Options are priced according to the nearest underlying VIX FUTURE as opposed to spot VIX index which is often quoted. The futures curve is often in contango meaning further out futures are priced HIGHER then near months and hence a 1 month ATM might be strike 16 whereas 12 month 16 strike may be deep in the money and therefore higher value. Vixcentral.com is a great site free site to check the shape of the curve. Unfortunately there is no free lunch and very difficult to find low cost long volatility structures.
Title: Re: VIX - Volatility Options
Post by: ItsAValueTrap on August 10, 2014, 11:06:14 PM
I did a couple trades in the volatility options, like a decade ago.  So my thoughts might be out of date, but since nobody is responding, I'll try....

The VIX options do decay over time, like any other option.  And they also trade in contracts of 100.  One of the complexities when I looked at them was that they were European exercise, not American exercise.  (i.e. you can only exercise them on expiration day, not before.)

Of course, this has the effect of reducing the value of the longer dated options, and they can trade for less than their intrinsic value.  (e.g. if volatility hits 70 in a crash, your calls with a 20 strike price and 6 months until expiry, are going to be trading for significantly less than 50, because there's a good chance the VIX will be far less than 70 when you can actually exercise the options.)  This is a really important thing, because, unless the option is close to expiration, you'll make much less on calls on a spike in the VIX than you might expect with other (American-style) options.

All that said, for about 15 years, I've been looking for a good way to get long volatility (i.e. something that doesn't require perfect timing and won't decay really fast), and I've never found anything.  I find it much easier to be short volatility.

Aren't options that can only be exercised on the maturity date (European) less complex than options that can be exercised any time (American)?

Options with American-style exercise should be worth slightly more than European options.  The difference (usually it's tiny) only matters if you can get value out of exercising the option early.  This generally only occurs if the option is deep-in-the-money.
If there is counterparty risk (e.g. you think that your trade might not clear because the clearing system fails) then American options are worth more.
Title: Re: VIX - Volatility Options
Post by: RichardGibbons on August 11, 2014, 08:01:18 PM
Aren't options that can only be exercised on the maturity date (European) less complex than options that can be exercised any time (American)?

Yes.

Options with American-style exercise should be worth slightly more than European options.  The difference (usually it's tiny) only matters if you can get value out of exercising the option early.  This generally only occurs if the option is deep-in-the-money.
If there is counterparty risk (e.g. you think that your trade might not clear because the clearing system fails) then American options are worth more.

VIX is quite volatile and mean-reverting, so the discount can be significant.  The key is that the VIX is really mean-reverting and that seriously impacts the options prices.

For instance, on September 18, 2008, I decided to make a (tiny) mean-reverting bet on the VIX by shorting calls.  This was a bad idea.  :)

Expiry/Strike Sep 18,2008Oct 23,2008
VIX33-4251-79
Oct $30 Call$1.60-
Nov $30 Call$1.55$21.4
Dec $30 Call$2.00$14.80
Jan $28 Call$1.95$12
Feb $28 Call$1.90$10.60

So, the point isn't just that I'm a idiot.  It's that initially when the VIX popped from the low 20s to well above 30, on September 18, the deep in the money calls still weren't worth that much.  Even when the world was ending, and the VIX was super-high, I wasn't that badly punished on the longer-term calls because of the European exercise.  If I look at it the other side, if I only gain 5 times my bet when we go through the biggest spike in volatility imaginable, then that isn't a very good bet.
Title: Re: VIX - Volatility Options
Post by: ni-co on August 11, 2014, 09:45:41 PM
Because of the standard option pricing model another possibility to go long volatility is to simply buy options on anything (e.g. the S&P 500). Instead of e.g. being 100% in stocks you could shift part of your portfolio to cash and a part into options on the same stocks. This way you can have keep your market exposure while being long volatility at the same time.

I do this with part of my portfolio. E.g. this is one reason for me to own BAC warrants over the common stock. Simultaneously, you profit from rising interest rates this way, especially if you buy long dated options (Jamie Mai talks about this in Jack Schwager's Hedge Fund Market Wizards).

You could also buy puts and calls on the same stock/index with the same strike price to make it a pure volatility bet.