“The level of the VIX has two regimes: a high and volatile regime where it oscillates between 20 and 40, and a regime where it is quiet and stays between 10 and 20.”-Euan Sinclair
One of the most important features of the VIX for purposes of trading the index is that its returns have negative autocorrelation. This is a fancy way of saying that an above average return in one period will be followed by a below average return period in subsequent periods. Basically, what this means is that the volatility index has some properties of mean reversion. However, it is also known to have extreme readings in times of extreme market peril, real or perceived, and these of course jack up the mean.
But if you're trading the volatility index, it is more important where the index actually is then where a mean is that is perverted by extreme values. We just had one such extreme value, and it stands to reason given the characteristics of VIX returns, that we should have a relatively calm period of lower returns following such an extreme volatility blow-off. Based on this logic, we have been shorting the VIX ever since August 6th.
You can see above very clearly that these high values would drag up the mean, and when you analyze the dataset of all VIX values it is clear. The mean is $19.48 and the mode is $12.42. This is a big spread. One of the primary cornerstones of my past successful VIX trades is that the mode is more important than the mean. This is why I think it is very possible that we miss the typical September seasonal VIX spike, given the severity of what we just experienced.
One of my market mentors, Seth Golden, also hammers home this point. The VIX is mode reverting, not mean reverting. So, for traders, it is more practical to say that the VIX is mode reverting, then mean reverting, given the propensity of extreme readings. If you trade the VIX as a mean reverting product and use $19.48 as your target, you will bleed money. My most successful public VIX trades have been based on assuming that the VIX wants to return to its mode, along with qualitative and idiosyncratic insights concerning geopolitical risk.
In an article from October 10th, three days after the Hamas attacks, I recommended the December 20 $17 put options which paid $4.69 (entry $1.42) per contract on the date of settlement, and the December 20 $16 put options paid $3.69 (entry $0.91). This means they experienced a respective price gain of 230% and 327% in less than three months.
Next, I recommended that folks short the VIX despite some climbs associated with building geopolitical risk as Israel and Iran engaged in saber rattling. I recommended using the June 18th $14 put options to short volatility. I recommended them at $0.52, and they printed on 6/18 at $1.61. That is a price gain of 210%.
We had a historic volatility event on August 5th that has been written off as largely a false alarm. In some respects volatility has behaved in an even more strange fashion since the big event. The pace of the collapse has been the fastest in history. But last week even though markets went up considerably, volatility also rose. This type of decoupling is anomalous, and I'm thinking its a bit of a volatility hangover that should be shorted.
S&P-500® Index +1.45%, The VIX® Index +1.06 pts
Russell 2000℠ Index +3.58%, RVX Index +1.85 pts
Nasdaq-100 Index® +1.09%, VXN Index +1.17 pts
This appears to largely have been caused by market participants making a bid for convexity. I don't agree with the impetus of that bet. I think this is people who are hedging volatility and looking for an aftershock that I think is unlikely to come. In a logical vacuum, which is how many traders operate, there could be reasonable expectations for an aftershock if you're taking mean reversion seriously. If you're steeped in the reality that mode reversion is the regime you should look at the VIX through and you pair this with a likelihood for positive economic data and the increasing possibility of a 50 bps Fed Cut, it's looking like September will be a lot quieter than usual.
In this column, our trades on volatility so far have been about the post-election volatility crush that tends to happen. Furthermore, since the $VIX options we recommended are European expiration, the time value behaves very differently. This is a key consideration for even seasoned options traders when trading the VIX.
Buy September 18th, 2024 $15 put options on the VIX. They have gone down from our initial recommendation price of $1.00 to around $0.67 cents. I want you to lower your cost basis on this trade as I still have conviction it.
HOLD the November 20th $23 puts and $18 puts in anticipation of a post-election volatility crush.
