Options expert Lawrence McMillan, of McMillan Analysis Corporation, outlines how volatility trading is subjective and highlights the number of products that have been rolled out over the years in various efforts to track the volatility index.

Depending on your viewpoint, the holy grail of volatility trading can take on a different meanings.  To traders, it’s a product that tracks VIX closely, if not exactly. To exchanges and market makers, it’s a liquid product that draws a lot of trading interest.

To that end, a number of products have been rolled out over the years.  None has matched the VIX options and futures in trading volume and they have been the basis for nearly every other product: VXX, in particular (the Barclay’s Volatility ETN).

As we have pointed out in various recent articles, there are problems with most of these as far as tracking VIX goes. VXX, for example, has lost 99.7% of its value since inception in January, 2009.  It keeps reverse splitting, else it would be trading for pennies.  But it only mirrors VIX (and even outperforms VIX), when the term structure of the VIX futures inverts and slopes downward.  In particular, that is when the front month VIX future (July futures, currently) trades at a higher than the second month VIX future (August, currently). That inversion in the front two months is rare and generally only occurs during fairly steep corrections or bear markets, both of which have been rare commodities for years.

We recently wrote about the new ETFs—VXUP and VXDN—designed to track VIX daily.  It’s really too soon to judge how these are going to do in that regard, but from May 19 to June 15, VIX rose from 12.85 to 15.39, a gain of 19.8%.  VXUP rose only 2.9% over the same time period.  That’s because it was so overpriced on May 19, trading at a 13% premium to Net Asset Value (NAV).

As we’ve often pointed out, the best way to simulate VIX—not duplicate it (because it can’t be duplicated)—is to take a short-term position in the VIX futures and roll them over. A short-term position in VIX options is the next best thing.

But traders have also realized that a product that settles to VIX will track it over the short-term as well.  This has led to a somewhat ill-conceived preoccupation with weekly volatility derivatives.

Ironically, the theoretically best product in that regard—the CBOE’s Short-term Volatility Index (VXST) futures and options—have been a terrible bust. In fact, they have been delisted.   No new contracts have been added in the last month and the last VXST futures and options expired Tuesday, June 30.

For some reason, the only weekly product that has had successful trading volume is the VXX options.  VXX is based on the front two months of VIX futures and does not settle to VIX each week.  Furthermore, as we know, VXX has a very negative bias to it, falling 99.7% since inception.  No matter, the weekly options on VXX are popular with the public and they have almost all of the trading volume in weekly volatility options. 

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Tickers Mentioned: Tickers: VIX, VXX, VXUP, VXDN, VXST