A Derivative of a Derivative Is………

So another reason why I would recommend using VIX options with caution? You have to price volatility of volatility.

Yes, the VIX itself is an index of volatility. An option on the VIX prices based on the market estimate for the volatility of that volatility estimate.

Confused? Ypu won’t be after this episode of “Soap” (OK, that’s a dated joke, but if you ever catch a rerun, the show was hysterical).

Jamie in these vids actually explains the concept well. And trust me, it’s a confusing one.

Anyway, a customer yesterday bought the Nov 37.5 put, Nov. 60 call combo for $2.85. In effect betting on an increase in the volatility of…….volatility over the next couple weeks.

So just to consolidate some VIX-y points.

Realized volatility in the market continues to abate, though not as much as meets the eye as a 3-4% range is still a 3-4% range, be it up or down. The intraday swings are less violent however, and provide way less flipping opportunity. So it makes perfect sense for options volatility to contract.

The catch though is that options did not expect the insane volatility of a few weeks ago to persist. Options volatility severely lagged realized volatility throughout the move. And VIX near month futures traded with 20-30 point discounts to the actual VIX.

So this blip down in volatility this week is above and beyond the initial assumption that volatility would soon cave. And that’s what I find interesting.

Now the VIX and VIX Nov. futures are close to parity as I type, so that has changed. But relationship between implied volatility (predictive in nature) and historical volatility (lagging) is as before, with a severe options discount. Which as Bill showed the other day, is somewhat bearish.

So while it’s hard to call mid 40’s VIX “complacent”, as it was not so long ago that was a 2008 high, it is essentially telling us that Fear is over. Volatility is best viewed subjectively imho, and this move is a little too much too fast as I see it. I’m leaning modestly bearish.

Well, pretty clear the Volatility Explosion of 2008 has hit all asset classes. But not in the same way.

The graph’s here show USO 30 Day numbers up top, and 10 Day HV down below. And notice something different from, say, the indices?

Anyone? Anyone? Buehler?

OK, here’s the answer.

USO options volatility, the yellow line in the upper chart has spiked to a similar absolute level as SPY and QQQQ and IWM volatility. But volatility of USO itself has actually remained below options volatility. Even the “noisier” 10 day reading has peaked at levels roughly equal to the 30 day normalized options volatility.

I will go back to the same point as always; options prices depend on context. As high as regular stock options got, they never got to the levels of realized volatility in the marketplace. That does NOT mean they are a buy per se now, just that they have been a buy to this point of the move. USO however has the opposite behavior as options overpriced (to this point) the move.

Again, that does NOT necessarily mean they are a sale right here and now, just that they HAVE been a theoretical sale at times.

So, going to take my chances here as I found a spot I actually like shorting puts as the way to get long.

Heard some self congrats on the NYSE Friday for……….stepping in and keeping the market afloat. Or something like that. Remember as we got reminded 5000 times by 9:30 AM, the futures were down lock limit. We were sunk! That is, until the NYSE specialists, actual human beings and not machines or a bunch of Agent Smith’s, stepped in and met all the sellers. The implication being that if it was an automated exchange, no bids would have emerged.

Let’s unbundle this.

First off, we live in a world where we have ETF’s that effectively track these very futures. And they never stopped trading. It was quite easy to see where the *real* market was trading all morning if you spent about 2 seconds hitting them up. They were modestly lower than the futures lock, but not importantly so. At least while I was watching.

Secondly, futures aren’t there to “predict” an open. The best way to view futures and ETF’s pre-market is that THEY ARE the market  So if at 8:30, the SPY is 83, and at 9:30, the SPY is 85, the market actually rallied between 8:30 and 9:30. It’s logical to assume simply that bids came in over that timeframe. presumably in individual names.

Thirdly, if in fact it was some specialist magic that saved the market, how then to explain the Nazz did almost the exact same thing and rallied right after the opening bell? Last I checked, they ARE machines. Put the charts up and they almost superimpose.
And finally, I’m not real sold on the idea that a relatively low volume low, and millisecond VIX blip is so wildly bullish. It won’t effect my trading one iota whether this was in fact A BOTTOM or not. But c’mon, there has to be some actual pain associated with someone bailing, no? Who even had a chance to sell anything of any size? Or wildly over pay for options? The bobbleheads have crowed about countless days that “could have been worse”. And this was certainly one of them. Yet what exactly has that done for us, we’re at closing lows, down huge on the year.

But that last point is neither here nor there. There will be a bottom somewhere. Someone will get lucky enough to get their booking on TV that day and will get forever credited with calling it.

Bill at VIX and More runs a table of all the rather odd opening prints in the SPX yesterday. Add them all up as he does and you find that $145 million worth of SPX puts went up, coincidentally at a time they were calculating the VIX october settlement price.

Some ATM calls traded too, so the investment was even greater.

To put that number into perspective, the Oct 25 calls alone in the VIX increased in value by some $100 million from Tuesday’s close to Wednesday’s settlement price. And also remember that the $145 million is not a pure expense, as the puts all have some value.

With the benefit of hindsight, that opening print does not seem like an incredibly out of line value. For one thing, the market opened ugly. For another, the VXO, which does not move all that differently from the VIX, opened near there, albeit 15 minutes into the trading day. And in fact the VXO and VIX pretty much tracked each other all day from that point on.

My hunch is that the trade did not work as well as planned. The VIX police presumably determine a settlement price based on each opening quote or print in SPX. And as you can see, one might have reasonably assumed that settlement price would be higher, based on those VIX “prints” in the first 15 minutes.

Now another question is whether this was all legal.

I am guessing yes. It is veritably against the spirit of everything, it’s just absolute manipulation. Or attempted manipulation. But whoever bought the contracts is entitled to do just that; buy the contracts. It’s always been my opinion that we never should have made a statistic tradeable. And this action certainly reinforces that opinion.

Now as to restoring our confidence in the financial system, that’s another story.  This whole incident smells bad.

It also speaks to why we should not take every tweak in the VIX as gospel. The VIX got some love as an indicator because it ostensibly gauges fear levels in the options mart. But what significance is there in an artificially produced number that has no bearing on anything sentiment related?

Interesting trade yesterday in VIX products, as noted by Options Monster about 3 minutes into the video.

Customer sells 45,000 November 26 calls to buy 45,000 December 32.50 calls for $10.95.

What’s his bet? Currently the Nov. futures trade at an 8 pt. premium to Dec. futures (45 vs. 37). So if that spread evaporates, he figures to win big.

One way for that to happen of course is for the VIX to get slammed. If the VIX drifts back to the mid 20’s around November expiration, he’s pocket the $10.95, plus whatever residual value is left in the Decs.

He could theoretically make money on strong volatility as well if the marketplace is convinced that high volatility is the new norm. The spread would narrow in that case too, and the extra options premium on the Decs would evaporate. Remember he’s getting a $4.50 premium for the spread and there’s no cost of carry involved, Novs turn to cash. In fact the Nov 32.5 puts now carry less than $1 in premium.

So it’s almost a bet on the volatility of volatility over the next month. Interesting.