The Option Pit Method Easy VIX III VIX

The Option Pit Method Easy VIX III: VIX Term Structure And VXX Option Pit

What we will cover today • • • Reading the VIX and the rubber band Understanding the VIX Calendar Creating a FV for VIX futures Contango pricing Backwardation pricing How to know when VXX moves?

Trading VXX What is the VXX and VIX doing today? This is a condition and is based on Price changes in the VIX underlying and the future changes We want to set up how the rubber band stretches and snaps back That is the central theme of volatility reversion How is the rubber band priced? This is what we do today.

Think of it this way VXX moves based on the VIX futures daily time -VXX in contango we can estimate a drop over -VXX in backwardation we price short term moves

Finding VIX futures Fair Value With VIX at 12, Zone 1, VIX futures are usually 2. 0 over parity with 30 days to go. That future premium drops about. 50 per week (more on this) That gives us the rubber band in the not stretched mode. Once the future premium changes with respect to the calendar WE CARE The rubber band stretches and this is our signal to price trades in VXX

VXX

Finding Fair Value • V= 1/ Sqrt (T) The general relationship for volatility and time. – There are other models available, just stick to one and use it – Solving for VIX future premium: • Sqrt(DTE)/3 will approx fair value of the premium in Zone 1 and Zone 2 • So let’s calculate today’s prices

Let’s price today

With VIX Cash 17. 40 May 29, 2018 1 DTE sqrt (1)/3 8 DTE sqrt (8)/3 15 DTE sqrt (15)/3 22 DTE sqrt (22)/3 39 DTE sprt (39)/3 even today’s value is even. 94 -. 75 1. 29 -1. 30 1. 56 -1. 30 2. 08 -1. 35

VXX and future Fair Value • Any time VIX is close to FV in contango VXX decays rapidly, up to. 25 per day in some cases • Once the future premium shrinks below FV, VXX moves much slower – Why? Because the futures “want” to get back to fair value and VIX needs to drop farther • Shorter term trades work better in FV or better • Longer term trades work better < FV

Context for VXX moving

Monday May 21 st 2018 VIX closes 13. 16 Look at the VIX Jun future price

Pricing the current mark (not Sebastian) • Each spot on the calendar has a unique value since each has a unique volatility for it’s position in time – If we chose position closer to expiration we need the underlying to move (think Backward) – If we chose positions farther from expiration we want the underlying melt slower (think Contango) • In general the VIX futures are predicting where the cash will be the TV for time allowed

Finding the Cheapest (or) Expensive • This exercise tells us where we want to buy calls or puts. – In trading terms, which way to lean – We can have an opinion about VXX but we want the quickest path to success 1 DTE sqrt (1)/3 8 DTE sqrt (8)/3 15 DTE sqrt (15)/3 22 DTE sqrt (22)/3 39 DTE sprt (39)/3 even today’s value is even. 94 -. 75 1. 29 -1. 30 1. 56 -1. 30 2. 08 -1. 35 These futures are saying the VIX cash should be lower in the short term but are decaying up

Setting up trades • We learned earlier that the Vol futures and VXX move to the gravitation pull of VIX cash – This is either backwardation or contango – Now we have a TV for the gravitational pull With the VIX futures Moving down the pull Is down and known direction

Setting up trades • • • 1 DTE sqrt (1)/3 8 DTE sqrt (8)/3 15 DTE sqrt (15)/3 22 DTE sqrt (22)/3 39 DTE sprt (39)/3 17. 35 16. 65 16. 10 16. 05 even today’s value is. 94 1. 29 1. 56 2. 08 even -. 75 -1. 30 -1. 35 TIME IS CHEAP! If the VIX futures look cheap (less than TV) I look at the upside for VXX If the VIX futures look expensive (more than TV) I look at the VXX puts So where are we today?

Decaying upward

VXX options today

VXX from last Week May 21 to today VIX cash stayed around 12. 5 most of week and that arrested the movement in VXX - Lower future premium did that - When VIX futures are so compressed VXX does not move much

Using the calendar to price • Last week VXX was not really moving – Put Time spreads to the far part of the decay can work • Always hedge a bit- remember our trade idea last week? – Once we identify the pace of motion one must still determine how the trade will pay • Where is the VIX cash and future now • Where can it go to expiration (down and up) • Where it is likely to go (where it is now) – Let’s do this for today

Pricing out today • Setting up risk reward based in reality and TV

Pricing Realized Vol in VXX Use the Call bid less the Put offer to find where VIX is

Backwardation pricing • Once VIX starts to move things get interesting – Why? Because of the tendency for VIX to go back where it came from.

Backwardation Pricing • VIX going backward makes VXX move like wildfire – This sets up the trade so we can estimate some realized vol pricing • 1% move per day is a 16% vol • VXX moved 13% today which is more like 208% realized move – Jun 15 options are 83% which seems cheap for a a couple day hold

VIX future tricks • Flat VIX curves mean crazy moves for VXX • Most times, VIX cash moves up will be absorbed by the VIX futures – the expected move becomes real • The VIX future moves will be according to the 50 delta rule for 30 day futures • Favor the side the has the most edge • TOUGH TO GET VXX DECAY in Backwardation

Is there a trade today?