The VIX Term Structure after 7 February 2012

Dear Friends and Students,

Like many of my fellow options traders, in my initial trading career I focused only VIX-cash (the CBOE Volatility Index) and what was interesting is that I simply accepted the inverse relationship between VIX and SPX (S&P 500 Index) without challenging why and whether the inverse relationship is always true. As in my previous posts suggested, there are many myths about the proper application of the VIX. Since there are so many stories on this subject, let me use one to illustrate and the story goes likes this:

On Monday, VIX traded 17.76 and last night VIX traded 17.65. Last week, VIX traded 18.55. So, let me apply my “technical analysis” on a VIX daily chart (like below) and draw the lines to come up with my outlook of the VIX which has been commonly accepted as the fear gauge by the various market participants.

Source: Optionsxpress

The more I study this subject, the more I realize that this type of analysis cannot be applied to this animal because it is inaccurate. There are many reasons why this is the case and I don’t have the time to sit down and verbalize all of them for you.  For one, we cannot trade the VIX and if you have read my related post before, you should know by now. So, how accurate can it be to apply technical analysis on a “VIX’ chart.

Another reason has to do with the market makers’ adjustments. How many of you notice that in a classic week, for example, the VIX will be “adjusted” on Fridays and re-adjusted on the following Monday to account for weekend decay?  As a result, the VIX reading on Friday and the following Monday are not reliable unless you have made your own adjustment to account for the weekend decay.  If you don’t know this, it is not your fault because I am not even aware of any self-proclaimed options trainers in Singapore who are taking about this. Why? This is within the exclusive knowledge domain among the options strategists who were formerly the market-makers. So, I shall not elaborate further and let it remain in the place it is supposed to be.

If you now accept that applying technical analysis on VIX-cash can be risky and sometimes not accurate, what is your response? Learn how to interpret the VIX term structure and this is the way forward in my opinion.

So, as my new story continues, over the last five trading days, I notice a divergence between the shorter-term VIX Futures and the longer-term VIX Futures. If my memory is right, it has occurred twice during this period and in this year. It does tell me that not every market participant has the same view on the market outlook. However, overall what does the term structure say? It is still in Contango and thus, supports the bullish case for the broad market.

Source: http://cfe.cboe.com

VIX February is now only trading 1% premium on the VIX-cash which is all right. Keep in mind that we have one more week to VIX February expiration. The VIX-cash calculation in any case will not take into account February. As I can see from the chart above, there is still some nice “juice” for Apr, May and even June when they are trading at 3% to 5% premium. If one takes a bullish outlook, certainly bearish strategies on VIX Futures or VIX options, or a combination thereof can be considered.

In case you wonder how long this Contago can last, my response is “I don’t know”. I will wait for the answer from the term structure. Until then, it is still a good climate for the bulls I must say. If you are my students, you should know this sentence – trade based on what we see and not what we think!

As some of you may know, one of the products in my portfolio is VXX. So far, after the FOMC meeting last week, VXX has broken the 25 handle. With the Greece saga coming to a temporary resolution as of yesterday, it looks like that there is still room for VXX to go down from the current level (slightly below 24) to the next major support at the 20 handle.

Source: Optionsxpress

Do not under-estimate the power of this move.  A novice trader who does not understand this product may choose to apply bullish strategies on SPY or the index SPX itself.  A more experienced and educated trader on the other hand will look at VXX and asks how to apply what he knows to get a better bang for the buck. So, if he is looking at VXX to go down to the 20 handle, it is a 16.6% move. Can SPY make the same kind of move? Of course not. In this case, applying bearish strategies using VXX options should make more sense, isn’t it? This is by far a better play than deploying a bullish strategy on SPX options or SPY options I must say.

Some of you may not understand what I am talking about in this post. This is ok because you are now aware of what you have yet to know and trust me, I don’t have the intention in this post to put you down.  I recalled a year ago, I also did not know much about this subject and thus, I made the commitment to get education on this subject because I know this is how I can gain an edge over many other options strategists in Singapore.   This is me.  I have this statement to all my students – the moment you are ahead of me in this area, it will mark the end of my instructorship on this subject matter.

You should know by now that if a self-proclaimed options trainer tells you that options trading is easy, he is clearly a liar.   If the trainer says that it is easy because you can sit in front of the screen for only 15 minutes and you can walk away and start dreaming how much money you can make from trading options, he is a liar.  And if the trainer in his course or program does not even talk about all the stuff I mentioned – term structure, volatility skews, etc, all I can only say that he  is merely sharing with his students what he knows but there are still a lot I guess he does not know.  The reality is that the former market makers have always an edge over many retail traders because they truly understand how this game works – volatility is the word.  Why would you choose to pay someone who only knows the retail side of the game (and by the way it consists of only a very small portion of the entire knowledge domain on this subject)?  Does it make sense to you?  Go figure.

Best trading!
Jack:)