Condor Options

In recent days, the [tag]RVX[/tag] (Russell 2000 [tag]volatility[/tag] index) continues to track the [tag]VIX[/tag] (S&P 500 volatility) and [tag]VXO[/tag] very closely, but this shouldn’t be happening given the recent out-performance of large cap equities relative to small caps. As RUT got plowed last week versus SPX and OEX, we should’ve seen the gap narrow between the RVX and the VIX/VXO in absolute terms, but we didn’t. The first chart shows the relative underperformance of RUT:
The second chart shows that, in spite of this underperformance, the indices’ respective volatility trackers did not converge as they would be expected to (we should see the RVX catch up to the VIX/VXO somewhat, rather than just mimicking them):

One guess we have is that [tag]hedge funds[/tag] and institutions may be using the [tag]ETF[/tag]s as primary hedging vehicles more regularly now, whereas in prior years they would’ve just bought puts. If true, that means that important information isn’t being registered by the CBOE’s volatility indices.

We’re also thinking that there’s a decent volatility [tag]arbitrage[/tag] opportunity here: if our hypothesis is correct that there is more real volatility in the small caps than is being registered in the RVX and in option prices, a long [tag]straddle[/tag] on IWM (going long volatility) combined with a short [tag]iron condor[/tag] on SPY (shorting volatility) should let us capture any unregistered difference. Since volatility is generally a good deal higher recently, we’d pursue this arbitrage trade as a 2:3 ratio (2 IWM straddles for every 3 SPY iron condors).