We closed our long Dec $30 put position today in VXX, as the risk of an upside move in volatility was greater than the downside in roll yield from the VIX futures. We considered selling weeklies at .58, but that risk was greater due to the limited downside. We will look to re-enter on any significant VIX spike, but at this point, the January puts would be more attractive.

For most of the month of November, the negative roll yield on the VXX was fairly low, frequently in the 4-5% range. The reason for this primarily rests with the month of December, and the inherent seasonality of the VIX.

The holiday market closures (extra decay when stocks sit idle) and seasonality of the equity markets have huge December and January VIX effects. The S&P’s top performing month since 1950 is December, and it is also #2 for the Dow Jones Industrial Average. As slowly rising markets are inversely correlated with a rise in the VIX, the options market anticipates lower volatility, and investors are unwilling to pay a high price for S&P options.

The chart below, courtesy of Vixandmore.blogspot.com, demonstrates the distribution of annual VIX low points. Clearly, December has a significantly high probability of being a low point for implied volatility for the entire year:

Source:http://vixandmore.blogspot.com/2011/12/december-is-cruelest-monthfor-vix.html

Now we can assess the damage that will be done to the VXX. It will hold all December VIX futures at the open on Wednesday, and will be rolling into January for the next 23.5 trading days. Current December and January VIX futures at the close on Monday:

The negative yield as a daily calculation:

2.05/16.60= 12.3%. This essentially means that the VXX will fall by .123 / 23 x $31.7 = .17/day, every day, all prices remaining stagnant. If the January and December futures fall closer to a spot VIX of 15.2, then there will be additional decay to the ETN.

As the VIX falls below 15, a better option for hedging volatility is the VIX options, as they do not carry the headwinds of the VXX. In fact, deep in the money VIX options look attractive when the VIX hits yearly lows, as they have less extrinsic value and offer quick returns in the case of market sell-offs due to ineptitude in Washington.

The VIX term structure reflects the VIX formula at future points in time. Essentially, the S&P options in the months out on the curve are the data points for the VIX structure. Just like the VIX, the midpoint of the bid/ask spreads are weighted by their distance from the S&P index’s current value. The implied volatilities are calculated to arrive at a VIX measurement for that point in time.

The other term structure reflects the VIX futures pricing. These are the contracts priced on anticipated VIX levels at points in the future. Clearly, these two measures of volatility do not agree, as the actual S&P options have an implied volatility that is lower than the futures pricing.

It is almost as if the futures have an additional layer of time decay, above and beyond the extrinsic value of the S&P options. It is critical to understand this if you are investing in VIX futures based exchange traded products. As the time to the contract moves to the spot price, or today’s VIX level, the two values converge.

The November VIX futures, which expire at the close Tuesday, are in lock-step with the actual VIX. Yet the December futures are 8.5% higher than the spot VIX. January diverges from spot by over 12%.

VIX Volatility Index values generated at:  11/16/2012 15:14:50

Apple shares did little today, but the Apple VIX made a significant move, and that was to the downside. VXAPL, the ticker for Apple VIX, fell 10.2% to 32.71.

http://www.bloomberg.com/quote/VXAPL:IND/chart

During the last several weeks as the sell-off in Apple shares picked up steam, the CBOE’s  index of Apple volatility rose from 25 in early September, to over 44 in late October as the puts on Apple were bid high and skew developed in puts versus calls. The only higher measure was 48 in April, when Apple topped and began a $640 to $530 correction that lasted about six weeks.

Since VXAPL was created by the CBOE as a measure of Apple volatility structured similar to the VIX formula, the historical average is 32.52, almost precisely today’s close. In 2012, VXAPL has averaged 31.82. By either measure, it is apparent that Apple volatility has mean reverted.

This may indicate the steep sell-off in AAPL is nearly through. The CBOE has filed with the SEC for options on the Apple VIX, similar to options on the VIX, as well as for several other stocks and ETF’s, like ones holding gold and oil.

People associate falling markets with a rising VIX and as a pure correlation, VXX rising. Not only is the rising VIX not perfectly correlated with a falling market, but the VIX rising is not a pure correlation to a rising VXX. This is where it pays to know how all of these indices and exchange traded products are constructed.

The VIX is heavily weighted toward the December S&P index options, and after tomorrow, it will roll into January as the next-term option structure. The VIX does this one week before index option expiration, so as to avoid unusual OPEX fluctuations. Next week, the VIF, or the VIX far month representing the January options, will have a negative weighting in the VIX. I.E. the VIX will weight December at 1.25 and January at -.25.

VIX near and next month volatility: (VIN becomes VIF on Friday’s close)

December has very low seasonal volatility tendencies. So next week, and essentially today in fact with one day to roll the index options for VIX calculation, the VIX is overweight December volatility. December and January options price in a lot of time decay due to the holiday season market closures, as well as seasonal equity trends during the holiday season.

No matter how you view the fiscal cliff, or the long-standing ineptitude of government leaders, the markets will do what they do. And it’s telling you something during this sell-off. The options market is not expressing high anxiety relative to the degree of selling that we’ve witnessed since September, and intensifying this week. Part of this is due to seasonal factors, but part of it is also probably due to historic low interest rates, monetary policy,  and decent U.S. economic fundamentals. Where else can you go to get a return above 1%? There are plenty of stocks with yields much higher than that while generating solid cash flow fundamentals.

The VIX futures fell today, therefore the VXX fell. The VXX should have fallen more, as it’s indicative value (the value of it’s holdings, not it’s trading value) fell even more than the trading price. This happens occasionally, but it is generally resolved quickly, as it is easily arbed out. Long futures and short VXX is that trade. See the indicative value here:

http://finance.yahoo.com/q?s=%5EVXX-IV

VIX Futures:

So the negative roll is now 4%, and you can see why the exchange traded products on the VIX were not up today. What can change this? If the market sells off significantly below the 200 sma, then the VIX could rise significantly. But at this point, we have seen a 6.6% correction over 37 days, the 4th longest correction since May of 2009. It is also the 4th deepest correction in two years.

So, until the VIX crosses above 20, there is not a lot of downside fear in the options market.