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Trading the VIX – CBOE Volatility Index and XIV ETF

If you really understood the VIX you would not trade it. On top of all the risks, which are frightening, it can be easily manipulated.

You – and I mean YOU – can move the VIX with as little as $50.

Only two kinds of people make money on the VIX, very smart – Ph.D. Stanford/MIT quants working for Goldman Sachs smart – and lucky people. Two kinds of people: quants & arbs and lemmings & lambs.

I have read THE BOOK on trading the VIX and I found it terrifying.

One example in the book, the author discusses a calendar trade that would appear to have fixed risk but literally has unlimited risk. And there are some general words like “the trader should be aware of price association between different futures.” That is the extent of the warning that your trade can blow up. When I asked the author, in person, about the lack of warning around this trade, he told me that reversion doesn’t happen very often.

VIX futures are normally in contango – future expiration prices are normally higher than front expirations. But occasionally they revert and the front month is higher than the back expirations. In those situations, you can place a calendar as a credit spread. In traditional option trades, that’s free money because you could exercise your longer-term longs if you were assigned on the short-term shorts. But there is no early exercise on VIX options.

If you placed a debit calendar and it became a credit, you would be upside down on your trade. I have shown an example of this where a trader bought a call calendar for $500. At expiration, it had gone to a credit (loss) of over $25,000. That happened because the VIX futures inverted. And it happened to people.

In response to the author saying this doesn’t happen often, I did some verifications (Trust, but verify) and found that over a two-year period it happened over 50 times. So, yeah, it does happen often and every one of those times a trader with a calendar would see a loss.

With regards to manipulation, here’s how that works. Since the VIX is a calculation of SPX option pricing (read the white paper for how it’s calculated), if you placed a few trades at the right strikes you could “tick” the VIX. I have demonstrated this can be done with as little as $50 on the right strikes. Why would anyone do that? It makes no sense. And this is the reason that we cannot trade the spot VIX, because it is so easily manipulated. This is well understood.

The VIX futures can be traded. And the price is set by the market – based on supply and demand.

VIX futures traders look to the SPX options that correspond to those futures to determine a fair value for that future VIX. Let me explain that. The VIX is calculated based on a weighted average of option expirations that straddle 30 days. If we wanted to look at the fair value of the FEB VIX Future we could look forward to the SPX options that straddle 30 days from that Future expiration and do the same sort of calculation. This is because, on the day that the FEB VIX future expires, it will be the same as the VIX, which will be calculated based on a weighted average of option expirations that straddle 30 days (e.g., MAR/APR). Since we already know what SPX options will be used to make that calculation, we could calculate a fair value for that “future VIX” which we can compare to the VIX Future. This is a relatively straightforward calculation.

That is what sophisticated VIX traders do to calculate the fair value for that VIX Future.

In the same way that the spot VIX can be manipulated, that fair value calculation of the FEB VIX future fair value can be manipulated by someone trading SPX options that expire in MAR/APR.

Trading the VIX is like eating fugu フグ. It doesn’t taste that good and if you screw it up, it can kill you.

Like moths to the flame, people are drawn to it. (Reminds me of Bitcoin lately.)

I frequently hear people say that they would avoid these risks by trading the ETN’s on the VIX. Well, all we have to do is look at the XIV this week to see those perils. XIV lost 90% overnight and now it is gone. Kaput. Something like $1.5B vanished.

The VIX ETNs are actually much more complex than futures alone because it has a blend of futures and includes a whole bunch of other things like rebalancing and redemption. Sophisticated traders use the ETNs as part of an arbitrage strategy between the VIX futures and options, e-mini futures and options, SPX options, and baskets of equities. It’s just math. (Quants and arbs.) Retail trades don’t do the math. (Lemmings and lambs.)

Sticking with the sushi analogy, it’s like saying “I would never eat fugu sashimi (trading VIX Futures and Options), but I love the fugu maki rolls (trading VIX ETNs).” It’s still in there!

A story that is as old as history. It’s modern day Siren’s Song, like in Homer’s Odyssey.

Ulysses and the Sirens by H.J. Draper
Ulysses and the Sirens by H.J. Draper

People cannot resist the temptation of shiny things which will eventually lead to their peril.

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Eric Hale

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