That VIX Magic?

How did those VIX numbers work in September?

On September 15th, the VIX exploded about 20% and shot above 30. The SPY closed at 120.09.

On September 17th, the VIX hit new closing highs for 2008. The SPY closed at 116.61

On September 18th, the VIX shot over 42, before The PPT came in with the Bailout and later, the Shorting Ban. Perfectly timed to get the maximum Gamma Whipsaw Effect of expiration day. The SPY went as low as 115 before closing at 120.07.

Yesterday, the VIX took at the highs of September 18th. The SPY closed at 111.38.

At each juncture, it sure looked like we had hit an important, capitulatory moment. And obviously the higher the VIX gets and the lower the market gets, the closer we are to the bottom. This may very well be THE bottom. But just keep in mind this is the 4th obvious Panic bottom in the last 2 weeks. They come on TV every six minutes noting only the last  moment, but conveniently forget there was lots of pain associated with chasing the other bottoms.

OK, quick primer on the VIX.

The VIX you see on the board is a measure that has existed only since 2004. So thus when you hear it hit a “record”, it’s not as impressive as meets the high. And it was indeed a record yesterday. Bill lists the prior Top Ten closes here.

Long story short, the VIX officially began in 1993. It estimated volatility by creating a “normalized” 30 day hypothetical ATM option based on some near-money options in the OEX. In 2004, the CBOE created a “new” VIX, that substituted SPX for OEX, and included more strikes. The “old” VIX changed it’s symbol to VXO. The chart above shows VXO since it’s creation, and as you can see, it spiked into the 60’s a couple times.

But wait, that’s not the whole story either.

You can still calculate what the VIX or VXO would have been prior to 1993 by just using their methodology on old quotes. And I’m not sure if there’s an official number for the peak in the 1987 crash, but I’ve seen numbers from 150 to as high as 172 for what’s now the VXO.

So just note that truly anything can happen. Among the sillier observations I have seen is the notion that the “cash”  VIX is some arbitrary amount above the VIX futures. That number set records too (VIX futures are relatively new) and kept going.

Basically, take it as a given that we are wildly over-panicked by options measures. It will resolve at some point and in hindsight we’ll have a New Rule that will ultimately prove as meaningless as the last batch of rules. This will resolve at some point in a massive rally, just tough to say when.

Well I’m not entirely sure I can grasp the concept of how a Double Inverse Short fund has distributions to pay out. What are they collecting? My head’s spinning.

Calling Greg? Or Roger?

Anyway, be that as they pay, they paid some distributions the other day. And the options froze. Then yesterday they reopened. Looking at DUG and SDS, as best I can tell, the options on the board are adjusted to include the distribution. In other words, take SDS. The distribution was roughly $3.82 per contract. If you buy, and then ultimately exercise any of the calls on the board yesterday, you would have the right to own the stock at the strike price PLUS you get the $3.82 distribution. Likewise if you own the puts and you exercise, you owe the $4.

So clearly in order to adjust everything on the board, you need to subtract $3.82 from the strike price.

Now that’s the easy part.

These options changed their symbol from SDS to SRY. And starting today, “regular” options return, with the symbol of SDS. These regular options are just ……regular.

Same story in DUG. The distribution is $1.80. And the old DUG options are now DUD’s. No joke. The old DZG’s are now DZJ’s.

Got all that? You won’t be tested. The key takeaway’s are that option owners ahead of the news were protected via these adjustments. And the new board will look confusing, so just remember to adjust the numbers to make sense of it

OK, so long as Inverse options remain all the rage, how about a quick refresher course?

The popular Double Ultra’s and Double Inverse Ultra’s track the daily percentage move of an underlying ETF. And then reset the next morning and track it again. And so on.

But over this course of time, this math does them all in, both the longs and the shorts. It’s the same principle as if you run a fund that goes down 10%, and then back up 10%. Net-net you’ve lost 1%.

Consider some hypothetical ETF, we’ll call it IYF and its composed of a group of financial companies (let’s call them IBM and GE and GM). Let’s say it trades at 100. And we list an Ultra ETF that goes up double the daily move in IYF (we’ll call it UYG). And let’s say also we list an Evil Twin called SKF that moves twice the inverse of the move in IYF. And both UYG and SKF trade for 100.

Now on Day 1, IWF goes up 2% to 102. Assuming the fund manager tracks perfectly to design, UYG would rally to 104 and SKF would decline to 96. Now let’s say on Day 2, IYF goes back down to 100, down 1.96% on the day, but unch. over 2 days. UYG would decline double that percent, back to 99.92, while SKF would rally double the percent to 99.76.

Yada yada yada, every time the underlying ETF revisits a price, all “trackers” will have a lower NAV than they did the last time the index was there.

Is there an arb?

Eh, not really. The reason is that technically you would need to adjust your position to keep dollar neutral. Consider the real UYG and SKF, As financials declined, you needed to keep shorting more and more shares of UYG to keep flat. Plus shorting both has other risks, like the new shorting rules that may have kept SKF way above NAV without clarification.

So bottom line is that even in a world where Ben and Hank let you short things, there’s better ways to make money than this. But I would just also that this constant overhang of math makes long term ownership a poor idea. They’re really designed for swing or day trading in my humble opinion.

So let’s say you want to do something bearish, and are perplexed a bit by this maze of confusing new rules.

What about a good old married put, as jkw reminds me in the comments yesterday?

A married put involves simultaneously buying puts and stock in equal quantity. Which is a synthetic call when you place the trade, certainly a bullish play at the time.

So how is this bearish?

Well, then you go sell your long stock out. Or as much long stock out as you want. And now voila, you have created a bearish postion.

Is it legal?

Seems like it is. I mean the position was bullish when you entered it. And then last I checked you can sell stock long. So not sure I see the flaw in this unless the Federales mandate you always need a long DELTA.

The issue I suppose is that you are not allowed to actually exercise the puts when they expire. Or ever exercise them for that matter (unless you own stock). You can probably roll the puts though if the net of the roll is bullish for you. And you can also just sell the puts. Or you can take your chances the rule will be clarified or eliminated by the time October expiration rolls around.

Here’s another interesting and wonderful byproduct of our New World Order, the SKF is effectively non-operational.  

Due to the emergency action announced by the Securities and Exchange Commission on September 18, 2008, temporarily prohibiting short sales of shares of certain financial companies, Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF) are not expected to accept orders from Authorized Participants to create shares until further notice. Unless notified otherwise, shares will be available for redemption by Authorized Participants as normal. The shares of these ProShares are expected to trade in the financial markets today, but may trade at prices that are not in line with their intraday indicative values.

So in other words, sounds like you can’t create “new” shares. John Gabriel of Morningstar has a great rundown of the situation here (hat tip Trader Mike).

The nickel version is that Pro-Shares does not short the component stocks themselves, they do swaps with third parties (sounds like something from some swingers in the 70’s, lol). But those 3rd parties can’t short anything now, so ProShares has to either just take on an unhedgable risk themselves or change their prospectus so that they can short stocks themselves AND get legal permission. So for now, it’s frozen. Frozen meaning no new shares can be created. If you own shares though you can still redeem them for NAV.

But no reason to do that, all this caused SKF to trade at a 5% or so premium to it’s NAV on Friday. So you’re better off selling than redeeming.

So going forward, does this present an opportunity? Well, I strongly doubt you can short the stock here, but what about taking a short delta in options? I mean SKF is overpriced, right?

Well, what can you do against it? You can’t short any component stocks unless you want Ben and Hank taking over your biz.

What about shorting XLF or UYG?

Now we’re talking. But here’s the rub. IF you can short SKF near where it’s actually trading somehow, and IF you can short XLF or UYG near where they’re trading at a given time, you will eventually make money if the SKF is this far above NAV. You’ll really make money if they resolve this in the next couple days. BUT I suspect the risk of such a play is ginormous. Why is a 5% premium in SKF a magical number, maybe it goes to 10% or 15%, who really knows? Remember first of all none of these pesky issues were accounted for when they banned shorting to begin with, what confidence should we have they’ll figure out how to unfreeze this thing any time soon? If that’s even something desirable to them. The Powers That Be may just as leave let this remain unresolved.

And remember also, SKF resets every day. It aspires to move twice the inverse percent of the IYF in one given day, nothing beyond that. So *errors* may compound each day until they figure it out.

Bottom line is if you’re running pretend capital and can double everything down and can figure out a way to short both sides every day, you’ll eventually win. But you may get incredibly incredibly squeezed in the meantime. Very similar to playing a stock merger arb where one side is a discount that will *probably* resolve. Tough to price *probably*.

There are going to be myriad odd opportunities going forward as the price of everything adjusts to a world where you can’t short the financias. And then inevitably goes back to a world where you can. SKF is clearly going to provide one of those opportunities, it’s just a dice roll into the unknown to see how it pans out though, a roll I do not plan to take at this point.

……..And just an aside to show the lunacy of this Short Bulletin Board we’re going to see soon, these Third Parties that do the swaps with ProShares are going to show up on some list as a major short player in every financial. And I’ll bet we’ll also find they keep shorting more and more on the way down. Those Bastards! Whoever approved SKF and the other Inverses should be courtmarshalled.

Oh wait, it was the SEC, nevermind.