VIX ETPs, Inter-Relationships between Volatility Markets and Implications for Investors and Traders

Transcription

1 Not a Product of Research / Not for Retail Distribution Citi Equities I U.S. Equity Trading Strategy VIX ETPs, Inter-Relationships between Volatility Markets and Implications for Investors and Traders February 26, 213 Spencer Cross Volatility Head Trader

2 Jan-1 Mar-1 May-1 Jul-1 Sep-1 Nov-1 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 VIX Futures: Settlement and Liquidity VIX Futures Settlement The settlement day is 3 days before the SPX options expiration of the following month (usually on a Wednesday). The settlement price is determined from a Special Opening Quotation of VIX on the settlement day (Wednesday) using opening price of S&P 5 options The last trading day of the future is usually on the Tuesday immediately preceding the settlement day. Settlement price can be significantly different from both the last future price and the last VIX spot price To avoid this price volatility in the last days of the VIX cycle, it is preferable to roll position out the week before expiry Liquidity of VIX Futures The majority of open interest and volume traded in VIX futures is in the 1st and 2nd month expiries This is purely an electronic market, while the options are traded in the crowd. VIX Futures Contract Contracts traded / day Front Month 54, Second Month 41, Third/Fourth month 14,5 Fifth thru eighth month 6,8 1, futures are equivalent to $1m S&P 5 vega Differences to the VIX settlement price Volume of first, second and third futures traded daily VIX Future at the close of the second to last trading day VIX Future at the close of the last trading day VIX at the close of the last trading day 7, 6, Front Second Third 2 5, 1 4, 3, , -3 1, -4 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 2 I Citi Equities

3 VIX Vega VIX Vega Vega Notional of VIX-linked instruments VIX Futures saw a slow start... but with the 8/9 credit crisis, activity grew 8x Millions VXX Other Short-term ETNs Reverse Short-Term ETNs Mid Term Reverse ETNs TVIX Mid Term ETNs VIX Futures Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Millions VIX Vega Outstanding Millions VXX TVIX Mid Term ETNs Reverse Short-Term ETNs (RHS) UVXY Other Short-term ETNs VIX Futures Mid Term Reverse ETNs (RHS) Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Date Millions I Citi Equities

4 Market Share: VIX ETNs vs. VIX Futures and SPX-linked options VIX ETNs impact on the market is strongest at the short-end of the term structure Total Short Term (front two months) VIX ETNs $171mm (7%) VIX ETNs $169mm (18%) VIX Futures $39mm (17%) SPY Options $212mm (9%) SPX Options $1,59mm (67%) VIX Futures $24mm (26%) SPX Options $462mm (49%) SPY Options $66mm (7%) 4 I Citi Equities

5 Using VIX options / futures to hedge an equity portfolio: How does one size his VIX hedge to an equity portfolio? 16% VIX front month future 1m returns vs. S&P 5 1m returns since 21 y = x % R 2 = % 4% % -4% y = 16.89x x +.84 R 2 =.691-8% -2% -15% -1% -5% % 5% 1% 15% S&P 5 returns Strongly negative correlation between VIX returns and SPX returns is very well-documented and relatively stable over time. 5 I Citi Equities

6 beta Using VIX options / futures to hedge an equity portfolio: However, magnitude of the relationship is less stable 6m beta typically varies between -.5 and -5 (average ~ -4) Low beta during strong equity rally and High beta during sell-off A $5M notional of VIX 1m call would provide a similar protection as a $2M notional of SPX puts. Hedge ratio is ~25% To hedge $2M notional of SPX with VIX Mar Fut at 17.5, we need only 3k contracts Rolling beta of VIX front month future 1m returns vs. S&P 5 1m returns day beta 252-day beta Beta is -2, which means.5 million notional of VIX Future is needed to hedge 1 million S&P Apr-8 Sep-8 Mar-9 Sep-9 Mar-1 Aug-1 Feb-11 Aug-11 Jan-12 Jul-12 Jan-13 Beta is -5, which means.2 million notional of VIX Future is needed to hedge 1 million S&P 5 6 I Citi Equities

7 Using VIX options / futures to hedge an equity portfolio: What is the equivalent S&P5 vega exposure? 6m beta of VXX vs. S&P 5 at-the-money implied vol varies per maturity For instance, the 6m beta with S&P 5 1-year implied vol varies between 1.1 to 1.75 (average ~1.5) The beta to implied vol tend to be more stable than the beta to S&P 5 returns A $2mm vega exposure on VXX (roughly $notional x delta) would be equivalent to a $3mm vega exposure to S&P 1-year implied vol ($2mm x 1.5). 126D Rolling Beta of daily moves: 1-month (constant maturity) VIX Futures vs S&P 5 atm volatility month vol 3-months vol 6-months vol 12-months vol Beta is 1.7, which means 1 million notional of 1-month VIX Futures (VXX) is equivalent to a 1.7 million vega exposure to S&P 1Y 5 implied vol Beta is.8, which means that 1 million notional of 1-month VIX Futures (VXX) is equivalent to a.8 million vega exposure to 1-month S&P 5 implied vol. Apr-8 Apr-9 Apr-1 Apr-11 Apr-12 7 I Citi Equities

8 Vol Spread Analysis: VIX ETN vs VIX Futures vs SPX Options Bid-Ask Spread for VIX ETN, VIX Futures and SPX Options (Jan 1, 213 Feb 26, 213) 2% 18% 16% VXX Bid-Ask Spread (% of mid) Generic 1st Future Bid-Ask Spread (% of mid) SPX Mar Qtr 149 Straddle Bid-Ask Spread (% of mid) 14% 12% 1% 8% 6% 4% 2% Average bid-ask spread.14% for VXX.36% for VIX Futures 11.64% for SPX Options % 2-Jan Jan-13 3-Jan Feb Feb-13 8 I Citi Equities Security Mid Current Spread Avg Spread Std Dev Spread VXX %.7% Generic 1st Future %.11% SPX Mar 149 Straddle (Screen) % 3.62% SPX Mar 149 Straddle (Floor)

9 Is Playing Roll Down in VIX worse than Shorting SPX Volatility? Var Comment:: The Strategy in red is a short 1m SPX variance swap with constant initial Vega. We adjusted the Vega of the two strategies to have a similar max drawdown. 9 I Citi Equities

10 VIX Futures: Is all flow one way or are there sellers offsetting? High Borrow Cost on VIX ETNs justifies using calls rather than outright long VIX ETNs have a high borrow cost (~2.5% for VXX and ~8% for UVXY). Outright longs have an opportunity cost equivalent to borrow rate, justifying going long using calls. Implied Rate Mid Ticker Spot EXP = Jan 214 EXP = Jan 215 VXX % -2.63% UVXY % -6.46% 1 I Citi Equities

11 Using VIX options instead of VIX futures: Options provide additional convexity 1-month* VIX Futures daily return vs S&P 5 daily return since Sep month 2 Call on VIX** daily return vs S&P 5 daily return since Sep 211 5% 4% 3% y = x x -.4 5% 4% 3% y = x x -.4 y = 68.84x x % 2% 1% 1% % % -1% -1% -2% -3% -4% -5% 1-month VIX Futures ( regression) -4% -3% -2% -1% % 1% 2% 3% 4% S&P 5 Daily Return -2% -3% -4% -5% 1-month VIX Futures ( regression) 1-month VIX 2 Call (regression) -4% -3% -2% -1% % 1% 2% 3% 4% S&P 5 Daily Return 1-month* VIX Futures daily return exhibit some degree of convexity vs. S&P 5 daily returns as shown earlier while options on VIX Futures exhibit an even higher degree of convexity. *1-month constant maturity ** 2 Call on the 1-month constant maturity VIX Futures 11 I Citi Equities

12 Using VIX options instead of VIX futures: Leverage on rich skew through call spreads VIX Mar'13 Implied Vol of Vol 1-month VIX 2 3 Call Spread* daily return vs S&P 5 daily returnsince Sep Strike 5% y = x x -.4 4% y = 68.84x x % y = x x % 1% % -1% -2% 1-month VIX Futures ( regression) -3% 1-month VIX 2 Call (regression) -4% 1-month VIX 2-3 Call Spread (regression) -5% -4% -3% -2% -1% % 1% 2% 3% 4% S&P 5 Daily Return VIX skew is upward sloping. Investors can leverage on rich upside skew by buying call spreads instead on calls thus trading out of some convexity while achieving a lower entry cost. * 2 3 Call Spread on the 1-month constant maturity VIX Futures 12 I Citi Equities

13 Disclaimer Disclaimer In any instance where distribution of this communication is subject to the rules of the US Commodity Futures Trading Commission ( CFTC ), this communication constitutes an invitation to consider entering into a derivatives transaction under U.S. CFTC Regulations 1.71 and 23.65, where applicable, but is not a binding offer to buy/sell any financial instrument. This communication is issued by a member of the sales and trading department of Citigroup Global Markets Inc. or one of its affiliates (collectively, Citi ). Sales and trading department personnel are not research analysts, and the information in this communication is not intended to constitute research as that term is defined by applicable regulations. Unless otherwise indicated, any reference to a research report or research recommendation is not intended to represent the whole report and is not in itself considered a recommendation or research report. All views, opinions and estimates expressed in this communication (i) may change without notice and (ii) may differ from those views, opinions and estimates held or expressed by Citi or other Citi personnel. This communication is provided for information and discussion purposes only. Unless otherwise indicated, (i) it does not constitute an offer or recommendation to purchase or sell any financial instruments or other products, (ii) it does not constitute a solicitation if it is not subject to the rules of the CFTC (but see discussion above regarding communications subject to CFTC rules), and (iii) it is not intended as an official confirmation of any transaction. Unless otherwise expressly indicated, this communication does not take into account the investment objectives or financial situation of any particular person. Citi is not acting as an advisor, fiduciary or agent. Recipients of this communication should obtain advice based on their own individual circumstances from their own tax, financial, legal and other advisors about the risks and merits of any transaction before making an investment decision, and only make such decisions on the basis of the investor's own objectives, experience and resources. The information contained in this communication is based on generally available information and, although obtained from sources believed by Citi to be reliable, its accuracy and completeness cannot be assured, and such information may be incomplete or condensed. Any assumptions or information contained in this document constitute a judgment only as of the date of this document or on any specified dates and is subject to change without notice. Citi often acts as an issuer of financial instruments and other products, acts as a market maker and trades as principal in many different financial instruments and other products, and can be expected to perform or seek to perform investment banking and other services for the issuer of such financial instruments or other products. The author of this communication may have discussed the information contained therein with others within or outside Citi and the author and/or such other Citi personnel may have already acted on the basis of this information (including by trading for Citi's proprietary accounts or communicating the information contained herein to other customers of Citi). Citi, Citi's personnel (including those with whom the author may have consulted in the preparation of this communication), and other customers of Citi may be long or short the financial instruments or other products referred to in this communication, may have acquired such positions at prices and market conditions that are no longer available, and may have interests different from or adverse to your interests. Investments in financial instruments or other products carry significant risk, including the possible loss of the principal amount invested. Financial instruments or other products denominated in a foreign currency are subject to exchange rate fluctuations, which may have an adverse effect on the price or value of an investment in such products. This document does not purport to identify all risks or material considerations which may be associated with entering into any transaction. Citi accepts no liability for any loss (whether direct, indirect or consequential) that may arise from any use of the information contained in or derived from this communication. This document may contain historical and forward looking information. Past performance is not a guarantee or indication of future results. Any prices, values or estimates provided in this communication (other than those that are identified as being historical) are indicative only may change without notice and do not represent firm quotes as to either price or size, nor reflect the value Citi may assign a security in its inventory. Forward looking information does not indicate a level at which Citi is prepared to do a trade and may not account for all relevant assumptions and future conditions. Actual conditions may vary substantially from estimates which could have a negative impact on the value of an instrument. You should contact your local representative directly if you are interested in buying or selling any financial instrument or other product or pursuing any trading strategy that may be mentioned in this communication. These materials are prepared solely for distribution into jurisdictions where such distribution is permitted by law. These materials are for the internal use of the intended recipients only and may contain information proprietary to Citi which may not be reproduced or redistributed in whole or in part without Citi s prior consent. Although Citibank, N.A. (together with its subsidiaries and branches worldwide, "Citibank") is an affiliate of Citi, you should be aware that none of the financial instruments or other products mentioned in this communication (unless expressly stated otherwise) are (i) insured by the Federal Deposit Insurance Corporation or any other governmental authority, or (ii) deposits or other obligations of, or guaranteed by, Citibank or any other insured depository institution. IRS Circular 23 Disclosure: Citi and its employees are not in the business of providing, and do not provide, tax or legal advice to any taxpayer outside of Citi. Any statements in this communication to tax matters were not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. Options This material may mention options. Before buying or selling options you should obtain and review the current version of the Options Clearing Corporation booklet, Characteristics and Risks of Standardized Options. A copy of the booklet can be obtained upon request from Citigroup Global Markets Inc., 39 Greenwich Street, 3rd Floor, New York, NY 113 or by clicking the following link, If you buy options, the maximum loss is the premium. If you sell put options, the risk is the entire notional below the strike. If you sell call options, the risk is unlimited. The actual profit or loss from any trade will depend on the price at which the trades are executed. The prices used herein are historical and may not be available when you order is entered. Commissions and other transaction costs are not considered in these examples. Option trades in general and these trades in particular may not be appropriate for every investor. Unless noted otherwise, the source of all graphs and tables in this report is Citi. Because of the importance of tax considerations to all option transactions, the investor considering options should consult with his/her tax advisor as to how their tax situation is affected by the outcome of contemplated options transactions. 212 Citigroup Global Markets Inc. Member SIPC. All rights reserved. Citi and Citi and Arc Design are trademarks and service marks of Citigroup Inc. or its affiliates and are used and registered throughout the world.6 13 I Citi Equities