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Volatility Reverting to the Mean

It is fortunate that I wrote my previous article about stagnant volatility the day before a strong ISM number came out which created a robust equity rally and a precipitous decline in implied volatility.  The VIX has decline nearly 15% this week.  VIX futures have fallen rapidly across the curve, but if this rally can be sustaining it seems that the futures have a long way to fall:

The front part of the curve fell quickly along with the VIX, but the months further out remain stubbornly high

The gap between the VIX Index and the 2nd month of VIX futures is at 6.86%, which is just off the absolute 6 year high of 7.46% established on August 6th.  This gap cannot persist forever:

The gap has to narrow, one way or the other

If the equity markets are able to hold onto their ground, then this looks like a great time to bet on a decline in VIX futures by shorting the October and months further out on the curve (over 32% for Jan 2011?!).  If instead we believe that September and October are going to be rotten months, then it would be wise to make a pairs trade through a delta hedged long option straddle in the S&P 500 along with a short position in the VIX futures.

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  1. bluffbody says

    I don’t see why in the second scenario you would also go short in VIX futures. By going long the delta hedged S&P500 straddle you are expressing your believe that realised volatility will be higher than the implied at the onset of the trade, corresponding to a believe in rocky markets the coming months. Why the extra short VIX futs position ?

Continuing the Discussion

  1. Long Dated Versus Short Dated Volatility | SurlyTrader linked to this post on September 8, 2010

    […] Tracking implied volatility surfaces can be very tricky without the right monitoring program or data collection methodology.  The benefit of tracking the surface is that it brings in all dimensions to options trading.  One of the anomalies that I have noticed over the last few months has been the persistence of high implied volatility levels on longer-dated options.  One easy way of seeing this is by looking at the ATM 1 year option implied volatility level versus the 3 month ATM implied volatility level.  Another imperfect way of seeing it is by noticing the steepness of the VIX futures curve. […]

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