I'm not going to pretend to understand most of your jargon. I try to keep it simple. I'm using TOS as my practice platform and here is an example I'll throw out. Assume volatility on SPY/SPX shoots up and the VIX goes from 14 to 20 tomorrow. You've been hit hard volatility wise on the short exposure side of your SPY butterfly. You've bought an APR VIX call at the 14 strike for 2.20. Compare this to having bought an AUG4 VIX call at the 14 strike for 4.40 (these are midpoint prices, used for example purposes only). According to the charts, on 2/28/14, when the spike occurs, your APR VIX call is now worth $440. Your AUG4 VIX call is now worth $420. Not much of a difference there. How is this not a volatility hedge? Of course the cost of the AUG call is much higher, but the time premium disintegrates slower, which is good. Depending on the size of the butterfly and its position, I could then either cash in on the VIX hedge and close the threatened butterfly for a smaller loss (or maybe even a gain), or hold on to the butterfly and hope volatility decreases a bit while I wait for further time decay. Am I missing something here?
Yes, I've looked into VIX historical data extensively before. I'm not sure about the utility of hedge ratios. I mean, the front-month VIX future consistently loses value more rapid than 2nd month future (thats what spun the VXX), so what is the continous hedge ratio between these two? If it was close to stable, wouldnt the VXX be in a stable downtrend instead of all over the place? I'm not sure if I understand you, but what you refer to as hedge ratios is in my mind is simply the amnt. of backwardation / contango present. So the AUG4 VIX call went from 4.40 to 4.20? How is that a hedge?
Yeah, you are missing a lot. But that is OK. There is room to learn. I'm not sure if you got your prices right. You are saying you "lost" money on the Aug VIX call? So your April went up by 220 and your Aug call went down by 20? How is that a hedge? I think may have gotten the wrong prices. But regardless, please do one thing for yourself, never EVER use single data points as justification for something to work. Every point in history is different. Markets are constantly changing and adjusting to new information and from past action. Honestly, the best way to hedge a fly is through trade size. Keep it small so you know what your debit risk is. If the trade goes against you, your risk is your debit. Don't try to hedge the damn thing 10 ways from Sunday. There simply is not enough upside in the fly to be taking losses elsewhere. I will offer a "solution" as to what you could do. First, trade smaller. Second, save some capital so that if the underlying DOES move out of your range, you could put on another fly which in essence simply synthetically creates one larger fly with a smaller payoff. Some guys do get carried away with this and start adding flys like a bad habit. Don't do that. Just have a plan in place and don't be reactionary. Losing money is a part of trading. Not all trades are going to work. The problem I see is guys will start getting creative while in the moment and something that started off as a simple fly turns into a 20 legged position at 10X the original size and risk and they don't know even know what they want the market to do at that point. The old saying "keep it simple stupid" is actually a pretty sound idea. The less moving parts, the better.
Thanks for your advice. I might have explained that example the wrong way. In monetary terms, according to the time decay graphical representation of the position (not the graph of the position at expiration), the actual profit on the position is $420. Which means the AUG4 CALL at the 14 strike would be worth 8.60 on 2/28, when the theoretical spike from 14 - 20 on the VIX occurred. Sorry for the confusion.
You do realize the TOS IV simulation assumes IV increases equally accross all maturities, correct? In other words, it's not realistic at all... In real life, the AUG option would never increase as much as the APR option. No way.
That makes better sense. But keep in mind, you were short a front month call that started off OTM and you were long a DITM Aug call which meant that you had significant long deltas driving the p&l, not necessarily vol. I mistakenly thought you were long an OTM Aug call along with your short OTM April call. Regardless, my previous post stands. I'm not saying you can't find opportunities in the VIX complex, I just wouldn't stack a VIX trade on top of another trade especially if that first trade is simply a fly until you completely understand what you are doing. "Make everything as simple as possible, but not simpler." Albert Einstein
Mav is right (there, I said it ), you need to do a little basic research on how VIX futures and VIX options work first. There is a very nice primer about VIX futures and options from one of the dealers, I will try to post it here tomorrow.
I think you're misunderstanding what sle is arguing; hedge ratios are referring to the number of futures of one maturity you'd have to be long to offset a position in a different maturity. VXX will lose its value in the long-term because of negative roll yield a typical contango environment (hence the constant reverse splits as the price falls), but that doesn't drive large price swings in the VXX; VXX's holdings consist of a futures position weighted between the front two contracts; if one goes up, the other one is almost certainly going to go up as well along with it. And yes, if it's the paper I'm thinking of (put out about 3 years ago), it's a very helpful one.
Are you saying I won't be able to rely on TOS's profit/loss graphs when I'm trading live with them? Here are the graphs of the 2 theoretical VIX positions: