Steven Sears in this weekend’s Striking Price is still on board the “Keep the VIX in perspective” train:

Stop obsessing about the VIX. The Chicago Board Options Exchange’s Market Volatility Index (VIX) is many things, just not all things. It can rise or fall for reasons that have more to do with trading type than market direction. During the week, some investors sold short-term hedges and bought long-term hedges. This exacerbated the VIX’s recent lows, and is one reason why the SPX skew — essentially the difference between put and call implied volatility — edged higher in thinly traded options that expire toward year’s end. [link]

We in the blogosphere covered this ground last week, and the general sentiment about not over-interpreting individual data points should only become more salient as we move into the summer months. There is some significant government data coming out this week, but earnings reports are drying up and this looks as good a week as any for the annual summer blandness to begin. It’s always fun to catch the Bubblevision staff pacing around the NSYE floor, dodging tumbleweed and wondering how many different ways they can rehash old stories.

We’re developing a market sentiment indicator that is testing pretty well so far and should prove helpful in checking our own biases from week to week. It isn’t ready for prime time yet, but the reading for this week is pretty close to neutral. We wouldn’t be surprised to see markets work off their short term oversold status by way of time rather than price - meaning that we could churn sideways here before resuming the selling or, by some miracle, finding new bullish leadership.

Now, to contravene our own injunction, let’s obsess just a little more. As of this morning, the short term volatility indexes (VIX, VXN, RVX, VXD) are all up 4-5%, and the VIX is teasing us with a move toward the broken trendline on the 2 year weekly chart. Markets are quietly and slightly up this morning, so this may well be institutions firming up their hedges in case oversold conditions persist this week. We suggest individual traders do the same.

In all our Calendar Options trades, we’ve been stressing that our strategy requires establishing positions initially having an even number of contracts, with a minimum of two contracts per leg for a double-calendar and four contracts per leg for a single-calendar. Reader Rob H. writes:

I took the Bonus Trade in IBM (Jun/Jul calendar) and had my order in for 8 contracts. Only one contract got filled at my price, and the market price has kept slipping away ever since. Since I couldn’t get an even number of contracts to apply position adjustments if necessary, do you think I should just pull the plug on this one?

Not necessarily, Rob. With a single calendar spread, our first adjustment strategy is to widen it into a double-calendar. The main reason we want to start a single-calendar with four contracts is so we can make adjustments without having to double the size of our position. For example, if we decided that the amount we want to risk on a particular trade is $3000, we don’t want to be forced to put in another $3100 and throw off the balance of our portfolio. So the split-position approach is intended to prevent an unexpected need for large amounts of new cash that we hadn’t planned to risk on that particular trade.

However, if we had tried to trade more contracts but couldn’t get filled, it’s okay if the adjustment adds to our position (assuming we kept cash set aside for this purpose)—because we had originally wanted a larger position. If IBM were to fall to $121 this week, for example, our usual strategy would be to sell half of our spread at 125 and to buy an equal (half) position in a calendar spread at 120. This would move our lower break-even point down and widen our profit zone, with only a small infusion of additional cash. On the other hand, if we wanted a bigger position anyway, we could just keep our full position in the 125 spread and add to it with a full position at 120, doubling our overall investment in the trade.

If we were to reach a point where a second adjustment is necessary, we could look at it similarly. The typical level-two adjustment would be to sell half of the position at 125 and open a half position in a 115 calendar spread, to form a center-weighted triple-calendar. But if we wanted to increase our position, we could just buy a full position at 115 to create an evenly weighted triple-calendar; depending on what the risk graph looks like, we also might want to add to the spread at 120.

There is one caveat, however. If a position needs adjustment, it might be because the underlying stock and/or the market is getting more volatile—perhaps dangerously so. In that case, we wouldn’t want to increase our risk on a trade that could be spinning out of control, and we’d have to take a loss and move on to the next opportunity. So if we’re sitting on a nice little profit right now (this morning our 125 put spread is trading about 8.8% above where we bought it less than a week ago), it’s worth giving serious thought to the fact that a pretty handsome return might turn into a loss because of the additional risk that a doubling-down adjustment strategy entails.

To the right is a fun little trade called the Straddle Strangle Swap. Look familiar? It looks a lot like a simple calendar spread or a butterfly spread. In actuality it is both, making it what I consider a sort of super calendar spread. Now lets take a look at how to construct these and what qualities make them so super.

Straddle Strangle Swaps are a specific type of Double Diagonal. They involve selling a front month straddle and buying a back month strangle. In our WAG trade pictured we sold the June 35 strike put and call and bought the July 40 call and 30 put. As you can see it provides positive Theta, and in this case negative Vega. (Using a longer calendar spread such as June/Sept would provide positive Vega). Straddle Strangle swaps are typically delta neutral but this will depend on the strike of the straddle. Like a calendar spread it will have negative delta as the market heads above the strike and will have positive delta when the market heads below the strike. So with all these similarities to calendar spreads what makes it so super?

Looking at the June/July 35 Calendar (image to the lower right) you can see that it is not as wide as the swap. Its break even points are 33.95 and 36.16 vs 33.20 and 36.72. This gives the Straddle Strangle Swap a 1.31 of additional width. (Using a longer dated calendar spread such as Oct/June would widen the calendar significantly but would still not be as wide as the swap). The calendar has positive Vega but has only half the Theta of the swap.

Another good thing about the Straddle Strangle Swap trade is that it is executed for a credit rather than a debit. This allows you to earn interest on the credit plus the buying power it utilizes. With today’s low interest rates it doesn’t amount to much. However, if you use margin in your account this can be a good way to save a lot of money from margin costs since you will be using your own cash rather than your brokers.

Last but not least one should take note of commissions implications. If you pay commission on a per-contract basis the swap is significantly cheaper, requiring only 4 contracts. The calendar requires 12 contracts to utilize equivalent buying power which means about 3x the commissions. However, if you are charged by the number of legs in the trade, like many brokers do, the calendar spread option is half the cost of the swap. Of course you should never let the commission tail wag the dog but the commissions implications are certainly worth paying attention to. All other things being equal, commissions may be the margin upon which you choose one over the other.

Stay tuned for more on Double Diagonals such as the Straddle Strangle Swap.

Our VIX post from yesterday got picked up by two of the deans of options blogging, Adam Warner (shown) and Bill Luby:

The Big Question for the VIX
VIX Jumping the Shark?
VIX and VIX
(and thanks also to Abnormal Returns for the link)

Not much to add in response to all this, except to agree that the increased coverage of this one instrument doesn’t change the fact that it still definitely serves a purpose. When all you have is a hammer, every problem looks like a nail, right? But just because some people erroneously use the VIX as a catch-all proxy for fear doesn’t mean that that particular hammer doesn’t still have its purpose.

The idea of a VIX hiatus sounds about right - at least in terms of parsing and explaining it. Surely those who have ears to hear will have understood by now that statistical measurements do not exert causal force - that any cause-effect relationship between the S&P 500 and the VIX moves only from the former to the latter.

Finally, what about the other volatility products, you know? RVX, VXD, VXN, QQV - those guys deserve more love than they’re getting.

New complicated products

Two product launches of note:

1. Yesterday saw the announcement of the Merrill Lynch U.S. Forward Equity Variance Rolling (FEVR) Index, which “measures the performance of a long S&P 500 volatility strategy designed to be both tradable and efficient.” As to be expected from a press release, they don’t provide much insight as to what’s really under the hood, just the obvious remark that this index “efficiently tracks volatility using a strategy designed to minimize the carry cost associated with owning volatility” while still capturing the upside of being long vol. The claim is that being long 25% this FEVR and 75% the S&P 500 beats being long equities only. No mention of any retail-friendly implementation of this index, either now or forthcoming. But that’s Wall Street for you.
2. Felix Salmon notes the introduction of some index ETFs that handle your allocation adjustments for you. His concern is that paying 25bp for a quarterly rebalancing might not be a smart use of your money, and we have to agree. The sponsors (PowerShares) should set the rebalancing back to annual, and cut the fee to 5bp. We’d buy that, or at least might consider putting our cousins and neighbors in such a fund.

Portfolio Update

A quick note to our members: again today we didn’t get filled on the order we’ve been working this week. Premiums just fell off too sharply today, perhaps in advance of the long weekend, and we weren’t in the mood to give chase.

The good news is that the same premium suckage that kept us on the sidelines has been fantastic for our current newsletter positions. Our IWM trade for June expiration is currently up about 7% after just a week; our SPY position is up 10%, which is our upper target for these trades anyway.

Reversal Readings

DIA - 2.76
SPY - 4.51
XLY - Consumer Discretionary - 0.53
XLE - Energy - 8.53
EWZ - Brazil - 5.52
XLB - Materials - 5.25
IYR - Real Estate - 2.12

Big retailers are seeing big selling in their stocks, and it’s putting pressure on our June/July RTH double calendar spread less than a week after we opened the trade. With RTH having dropped more than 3½ points already this week, and a long holiday weekend coming up, we thought it would be wise to reduce our risk by rolling half of our call-spread position at the 100 strike down to a put spread at 90, as follows:

+1 RTH June 100 call
-1 RTH July 100 call
for a net credit of $0.95.

+1 RTH July 90 put
-1 RTH June 90 put
for a net debit of $1.10.

This moves our break-evens down to 92.15 and 98.85 and reduces our delta from more than 26 to just over 11. Remember that we started off with two contracts per leg, so the one contract per leg in this trade represents half of our initial position—e.g., if we started off with 10 contracts per leg, we’d roll 5 contracts from the 100-strike call spread to the 90 put spread.