Condor Options

It’s been interesting to watch the VIX futures over the past few weeks.  While the action in SPX options has pushed the cash VIX up to fascinating extremes, the longer-dated VIX futures have been somewhat less responsive, as you’d expect.  Which is not to say that VIX futures have been unresponsive.

The chart above displays the cash VIX and current VIX futures prices as of about 10:00AM EST on October 17, 2008.  This term structure says two significant things:

1. The market makers and institutional traders who play in these products don’t expect the world to end.  In fact, the expectation is that implied volatility will come down from its stratospheric levels before Thanksgiving.  The November VIX futures expire on 11/18/08, two trading days after November options expiration, and they are pricing in about a 30% decline in implied volatility.

2. The longer dated contracts now reflect some of the recent turmoil, as they are all priced near 30 or above.  That means that, while we shouldn’t expect the next 6-9 months to look like the last 1-2 weeks, we should expect volatility on the order of the last 1-2 months.

Let’s review the meaning of these numbers: VIX futures, just like the regular cash VIX, estimate the expected movement in the S&P 500 over the next 30 days, displayed on an annualized basis.  So a cash VIX of 72 means that market participants expect the S&P 500 to move up or down by 20% over the next 30 days.  Explanations along the lines of “market participants expect a 72% move over the next year” are pretty counter-intuitive: do you know anyone, even any perma-bears, who expect SPX to be at 260 next Halloween?  But if you’ve been watching a price chart over the past few weeks, a 20% move over the next 30 days sounds relatively tepid.

Reading too much into these numbers can push you into a Princess Bride-style spiral of indecision.  Clearly, I shouldn’t choose the cup in front of me: implied volatility is ridiculously high here, and intuitively should be sold.  But you would expect me to think that, so clearly, I shouldn’t choose the cup in front of you: implied volatility still doesn’t seem to adequately reflect the insanity of real price movement, so volatility should be bought.  But you know that I’m a genius, etc., so it’s a trick question: stock prices could calm down at any time, but premium sellers today get to lock in high expectations about the next 30 days, so volatility should be sold.  But…

The moral of the story is that while volatility is extreme now, it should fall off a bit this quarter, and you should never start a land war in Asia.