Mish,
Real or Historical Volatility is calculated as the standard deviation of the variance of daily return of the underlying instrument such as SPX. Real volatility is backward looking.
The VIX Index is a real time measure that uses an estimate of Implied Volatility based on 30 day option prices on SPX. VIX is forward looking.
Since Real Volatility is backward looking (based on historical prices) and Implied Volatility is forward looking (based on expectations, fear, and greed) the two often go out of sinc. for example, because SPX dropped yesterday, may not mean that options are pricing in a drop in 30 days.
Financial modeling shows that Implied Forward Volatility is almost always consistently higher than Real Historical Volatility, that is, until that 4 sigma event occurs that causes Real Volatility to spike and exceed Implied Volatility priced into options.
As you know one component of option pricing is volatility and in options the implied forward volatility is consistently higher than real historical volatility on the underlying. This is what attracts the option writer, and also the reason why, under normal conditions, option writers (volatility sellers) make consistent small profits over time and option buyers (volatility buyers) make consistent small loses over time. That is, until that spike occurs and the buyers has a large gain and the writer has the large loss.
The VIX Future is cash settled based on the VIX Index (opening option prices = implied volatility) on SPX on the Wed before the third Friday in the expiration month. The Tuesday before the third Friday is the last trading day. The VIX future can be out of sync with the VIX index and at least in theory, the closer to settlement date, the closer the two should merge.
So it is not unusual for Historical Volatility to de-link from VIX Index (30 day real time implied volatility) and also de-link from the future which is 30 implied volatility at the settlement date.
It is a coin toss as to what will happen to VIX between close on Tuesday and opening on Wednesday so there is some risk inherent for a trader to cash settle the position rather than simply close out a position while it is still trading. To further muddy the water, there is a minor technical difference in the way cash settlement VIX is calculated on that Wednesday opening and the way it is normally calculated.
You correctly pointed out that VIX is thinly traded and that further complicates the matter. A 10 contract trade can move the market, just imagine the pain in trying to exit a 20 or 30 contract position at an inopportune time. In my experience the margin requirements may be too low, and I consistently dedicate more that the required margin to my trades.
Questions are welcome, this isn't easy stuff. I have been studying volatility for several years and have been trading VIX for a year. FYI, I am listed as a reportable position in the COT. I am really looking forward to the volatility seminar in London in two weeks. |
