@MosheW VIX strategy
December 3rd, 2022.
Updated April 26, 2023.
The following is an attempt to outline the underlying principles that guide my thinking, and explain the basic tactics involved in my core strategy, along with examples. I will not attempt to define every possible trade at every possible point on the curve. Nor will I address tail risk or margin. There are numerous ways to protect against and actually benefit from tail risk, and margin differs for different account types. I also engage in other trade types on volatility beyond what’s outlined here. But the core ideas below are what constitutes the bread and butter of my trading.
The basic strategy revolves around capitalizing on A) true mean reversion and B) the long term decay of long volatility futures.
When I say true mean reversion, I don’t refer to reversion to a MOVING average. I am referring to an extremely tight stable value that the instrument always comes back to. VIX is one of the very few tradable instruments that truly reverts to a mean, not to a MOVING average.
When I talk about the long term decay of long volatility futures I am referring to the relationship between spot VIX and VX futures contract curve prices. For the vast majority of trading days, VX futures trade higher than spot VIX. It’s not important right now to discuss why that is the case. This is a topic far beyond the scope of this note.
Because VX futures have an expiration date, the futures contract price converges with VIX spot price as the future approaches expiration. The majority of the time VX loses some value close to expiration as the gap closes between VX and spot VIX. This loss represents the long term decay of volatility futures.
Another important thing to know: VIX option prices are based on the VX price of the futures contract with the same expiration as the option. They are NOT based on spot VIX. This has to do with the economic law of no arbitrage pricing. VIX options need a tradable underlying, and VIX index cannot be traded directly, unlike SPX, which can be traded, by trading all individual stocks of the index. The VX future of the same expiration IS the tradable underlying for VIX options.
A lot of this can be confusing and complex, but it’s important to understand the environment you operate in, so I’m laying out the basics in this note for clarity.
This peculiarity of options priced based on the futures and not the spot index results in the same properties discussed above carrying over to the options from the futures: long term, VIX call options decay as a function of VX converging on VIX as expiration approaches. What this means is that there exists a structural advantage to be short VIX calls over the long term.
(Take a look at UVXY long term chart. Notice that it approaches zero. It is precisely because of this issue).
One other important point before I outline the strategy: even though VIX reverts to a mean, VIX spends the majority of its time below the mean. It spends far more days historically under the mean than above it. This is important when thinking about probability and direction.
Which brings me to the essence of the strategy.
Because of these two properties (mean reversion and structural advantage of being short calls), I can build and execute a strategy that does not keep me up at night. My strategy does not depend on being right on direction. All it requires is discipline and patience.
When VIX is above it’s long term mean, I short VIX calls. All kinds of calls. OTM. ATM. But mostly I look to short DITM. The higher VIX is the more deep in the money calls I short.
Recently at the October market lows, I shorted calls with the following strikes: $40 $37.5, $30, $28, $25, and a boatload of $15s.
I close these positions for pennies on the dollar as VIX reverts to the mean.
When VIX is at or below its long term mean, I enter into opportunistic positions that benefit from a potential rise in the index.
Because, as outlined above, I know that VIX spends most of its time under the mean, and because I have established that structurally, VIX call options have decay built into them and because I know that my feelings and thoughts and analysis, despite how smart they make me feel, are useless in the face of raw probabilities, I never, ever enter a long position on VIX that requires a movement within a certain timeframe to prevent loss. This is why I don’t short puts, I don’t buy outright calls. Not for the short term, not for the long term. My money is not a casino. I work hard for my money and I simply do not gamble.
This does not mean I am without tools when VIX is low or around the mean. To the contrary, the long term decay in call options provide me plenty of opportunities if structured correctly.
There are three types of trades that I have in my toolkit for that scenario.
The first type is a straight forward backratio
Buy one long ATM call.
Sell two short OTM calls at a strike and distance sufficient to cover the cost of the long call, and sometimes receive even a small credit.
This is usually about a 5 point strike spread, depending on VVIX and expiration date. I tend to do those 5-8 weeks out for best results. Monthlies are also much more liquid than weeklies, so bid/ask spreads are tight and I am easily filled.
As an example, I will use the February 2023 expiration. Current (as of December 3, 2022) quote for the following trade is net $0.52 credit, which should net immediately $49 after commission:
Buy 1 long call $20 strike, Sell 2 short calls $25 strike.
The P&L for this trade is as follows: if VIX stays where it is, I keep the $49. If VIX expires at 25, I get max profit, $500. If VIX goes above $25, I start to give back profits 2:1. My break even point on the upside is $30 VIX, not counting the $49.
Given that the probability of VIX closing above $30 is well under 10%, the risk/reward for this trade is exceptionally good.
The second trade I have for the scenario when VIX is around or less than the mean is a 3 legged position as follows:
Leg 1: sell one DITM short call.
Leg 2: buy one slightly OTM long call.
Leg 3. Sell two far OTM short calls (about 6-7 points above leg 2 strike.
As an example, here is a trade I entered on Friday (early December 2022) using January 2023 expiration:
Sell 1 short call $15 strike.
Buy 1 long call $23 strike.
Sell 2 short calls $29 strike.
The credit for the trade for $9.08, crediting my account $905 after commissions and fees, per lot.
Here is the P&L on this trade:
If VIX expires below $23, legs 2 and 3 expire worthless. My profit in that scenario is $905 less the difference between VIX closing price and $15. So if closes at $20, then my profit is $405 and so forth.
If VIX closes between $23 and 29, the profit is $105, because the long 23 and short $15 cancel each other.
If VIX closes above $29, I give back my profit in a 3:1 ratio. This places my break even at around $29.35.
[Added April 2023
The third type of trade I use is butterflies financed by short calls.
I am currently positioned for May expiration with the following call butterflies
20/24/28
21/25/29
Both were financed completely by short calls on VIX $39. The credit for the transaction was 0.03/lot.
Depending on VVIX, it’s best to layer into a trade like this 8 weeks ahead.
I’m positioned for June expiration with the following butterfly
20/25/30
Completely financed by short calls at 47.50.
Credit for the trade 0.02/lot.]
When VIX is lower or around the mean, I always put on all 3 types of the above trades. The exact balance between these is determined by the degree to which I’m biased towards an immediate move upwards, in which case I favor more backratios and butterflies which have more immediate and pronounced upside potential although the back ratios increase the volatility of the MTM portfolio, or if I think VIX will possibly linger around the mean for a while in which case I favor the 3 legged position because they do have more profit from decay potential than from upside movement. But notice that neither trade has downside potential IF VIX continues to go deeper down below the mean. I am not a gambler in a casino and I don’t trade direction.
In either trade scenario, as VIX moves through my profit zone to the upside, and reaches the b/e point for my positions on the upside, I am handed VIX on a platter to short DITM calls heavily.
If I reach that point with significant time left to expiration I *convert* the short calls from the previous trades to fewer DITM short calls, usually for a credit and for a significant reduction in margin requirements.
Wash, rinse, repeat.
Everything else is discipline and patience.
Discipline not to overtrade, and patience to trust the strategy.
#strategy
