A few days ago I suggested that the gap between the front month VIX futures and the VIX spot had gotten a little high. The gap has closed a bit, but I wanted to explain in more detail the suggested trade because I received quite a few questions regarding it.
The VIX index is a measure of 30 day implied volatility. The CBOE calculates the VIX as a weighted average of next term and near term S&P 500 option volatility. As volatility increases and decreases the number of options used in the VIX calculation expands and contracts, so the portfolio of options used to replicate the VIX is ever changing which makes the index non-investable. In order to *try* to replicate a long position in the VIX, you want to go long a representative portfolio of 2 month or less (preferably 30 day) puts and calls while delta-hedging the position daily. My suggestion was to delta hedge a simple straddle at the front month or the front two months of S&P 500 options. I deem that a sufficient replication for going long a representative version of the VIX. Will it follow the VIX exactly? No. But in trading I always tend to error on the side of simplicity – K.I.S.S.
The second question was regarding the VIX futures. Why are we going long options against the VIX futures? Should we be using VIX options instead? No. My point is to trade the basis of the VIX index versus the VIX futures which are an expectation of what the VIX will be in the future. When the August 2010 VIX futures trades at 27.3, it is saying that on expiration Wednesday morning, August 18th, we expect the VIX to be at 27.3. If you short the VIX futures at 27.3 today and the VIX is calculated at 30 on that Wednesday morning, then you will lose 2.7 points. So the point in my suggestion was to enter into a “pairs trade” in which you go long a representation of the VIX index and short the front month VIX futures because the gap between the two was at a historically wide level. This position would be pseudo hedged if you had $1,000 of long vega on the S&P 500 options that you purchased against every 1 VIX futures contract that you shorted.Download VIX White Paper