Video

#SaxoStrats
Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 18 January 2017 at 15:40 GMT

Product Watch: Getting long on VIX — #SaxoStrats

Product Manager, Options Trader, Educator
Denmark
  • It's difficult to know when exactly a bear market takes hold until after the event
  • Mitigating the fear factor through the VIX index is one way of controlling volatility
  • There are various strategies we can use on the VIX
  • Product Watch is a new feature focusing on key products

k
Volatility can be sparked by all manner of things including the
battle for coveted oil resources in the South China Sea. Photo: iStock
 
By Georgio Stoev

We all went through the bliss of this past holiday season so determined to finish the year on a high note and even more determined to start the new year on an even one.

About 45% of Americans started 2017 with some sort of a lifestyle resolution – lose weight, spend more time with family and so on. (I, for one, am substituting cigarette smoking with nicotine gums. I am getting more addicted to them than I was to smoking). 

But only 7% of the aforementioned 45% will keep those resolutions. It's tough enduring the ups and downs and putting the body and mind through stress. A few practices, like meditation, having support from a loved one could help the ones determined - "the steamrollers." 

In the marketplace, we also are having to go through the ups and downs of these ups and downs. Just go back a year when, for a moment, we thought Armageddon was on its way from China. Markets tanked more than 10% and we all thought it was going to get worse.

It was another bear market in the works, but we cannot predict when a bear market has arrived until it has firmly manifested itself. Hindsight is always 20/20. 

The 2016 Vix roller coaster
SPY Daily


Source: SaxoTraderGO

What can we do to control some of that volatility?

There are many ways to skin a cat and managing volatility is no exception. 

Step 1. Determine what is it that you are trying to accomplish. Is it to hedge the risk in the market? On the entire portfolio?

Step 2. Understand what the products are before using them. This is where most of us will stumble, potentially get in trouble and end up giving up. 

With so many choices of instruments on the Saxo platform, it feels like we are in Willy Wonka's Chocolate Factory. Which one is the right one? 

The Chicago Board Options Exchange holds a long tradition in volatility products, among other flagship products, such as the S&P 500 Index Options (SPX). And, of course, the exchange pioneered the listing of equity options on blue chip names such as IBM, GE and many others. The year was 1973.

Among its flagship products the Volatility Index, also referred to as the fear factor, is a measure of near-term market expectation as measured by S&P 500 stock index options. There are a plethora of other products tracking volatility on currency pairs, financial instruments and of course equity options. For full product overview check out the exchange's website.

Volatile history

Before we crack the code on the the product, here's the story behind the VIX. The VIX in its current form dates back from the early 1990s with its roots set in the 1980s, post the stock market crash of 1987.

Back then volatility was tracked by another volatility measure - the VXO which tracks the S&P 100 stock index.  

The 1987 market crash
VXO Market Crash
Source: Bloomberg

Coincidentally, in the late 80s, equities were making new highs on the back of fiscal and monetary stimulus. Moreover, in the months preceding Black Monday, global interest was rising on concerns and of inflation, rising US government debt and of course extreme bullishness by investors.

In one day, the equity index lost 20% of its value. In the following three weeks, the S&P 500 suffered a 33% loss. At the same time the CBOE volatility index skyrocketed from $20 to a high of $155 or 675%. 

Choosing the right volatility instrument/strategy 

Trading investors sentiment for speculation or protection is a little trickier than most other vehicles. You cannot physically own indices such as the VIX or SPX. So market participants use futures or options as a hedge or to establish a given market view. 

Equities vs volatility
Inverse relationship
 Source: Saxo Bank

Strategy 1
To gain an upside exposure to in volatility or VIX, investors could either buy an outright call or do a combination with another option through our Multi-Leg Option ticket. At the time of writing, VIX is trading near $11.70. If you expect fear in the market to rise over the next couple of weeks, you could purchase a $15 call option for $1.15 or $115 per contract with 27 days to go. Your upside will be unlimited while you risk the premium paid of $1.15. 

Strategy 2
The above strategy could be extended through the use of a spread, such as the bull call spread. Using the same 15 February 17 expiration but different strike price we could reduce the cost of buying an outright option by simultaneously selling another. This is an example of a vertical spread - The 15 FEB 17 15/19 call spread would cost half the single leg at $0.55 and will provide for ample upside (width of spread minus premium paid or $4-$0.55).

This is how you do it
m
 Source: Saxo Bank
 
Strategy 3
For those having access to futures trading you could consider a third option - the covered call. Using the underlying CBOE future, VXG7, you'd establish a long position in the future contract and sell a VIX option against it. The position is similar to selling a covered call on a stock you own. It is super important to trade same expiration on both the underlying and the option. The option is based on the future. In our case VXG7 (28 days to expiration) should be combined with the standard February expiration of 15 FEB 17. 

Another important consideration is the size of the contracts. While the VIX options have a multiplier of 100, the underlying future has a size of 1000. So for every one contract of the future you'd need to sell 10 VIX options. Or:

Long +1 VXG7 1/1000  16 FEB 17 at $14.20
Short -10 VIX 1/100 15 FEB 17 16 CALL at $.90

While the purchase of the future contract will require a margin of $6,837, the VIX calls will bring $900 in premium. Both of these products are cash-settled. VIX options are European and can only be exercised at expiration.

To gain on such strategy the underlying needs to move up. Your profit will be capped to the strike price of $16 and you'd make the difference between the initial and closing value ($14.20 -$16) or $1.80 or $1,800 (x 1,000). In addition you get to keep the premium from selling the 10 contracts and increase your total return to $2,700 or 40% ROR (initial margin/profit).

Some important considerations

Whatever you are view of the market going forward might be, you should consider using futures and options to diversify and protect your portfolio.

You should take time to investigate every single product/strategy before employing with your capital. Look for liquidity, sell options when the VIX is high and buy options when volatility is low.
Use your long (stock) positions to reducing your cost basis and reduce the risk. The lower the cost basis, the greater the opportunity of success in that investment.

Please make sure and reserve your spot for the upcoming OptionsLab webinar with special guest Russell Rhoads, CBOE director of education, as he provides an insight view of CBOE's long line of strategic instruments.

m
 Handling volatility is key to a well-constructed portfolio. Photo: iStock

— Edited by Martin O'Rourke

Georgio Stoev is futures and options product manager at Saxo Bank
2y
fxtime fxtime
Very valid point about size of contracts....I prefer to only short VIX when it is at market extremes though. But as you say there are many scenarios. Always enjoy your teams option commentary :-)
2y
Market Predator Market Predator
@Gerogio: as "Options ambassador" you do great Job for Saxo. I'm looking forward to new WOW with Russell Rhoads. I wish you keep aim to stop smoking!
2y
Georgio Stoev Georgio Stoev
Thank you both for following and your comments.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Tradingfloor.com permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Tradingfloor.com and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Tradingfloor.com is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Tradingfloor.com or as a result of the use of the Tradingfloor.com. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. When trading through Tradingfloor.com your contracting Saxo Bank Group entity will be the counterparty to any trading entered into by you. Tradingfloor.com does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of ourtrading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws. Please read our disclaimers:
- Notification on Non-Independent Invetment Research
- Full disclaimer

Check your inbox for a mail from us to fully activate your profile. No mail? Have us re-send your verification mail