A Breakdown of the new OIL VIX Contract

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I have to admit, there are very few traders that are as excited as me that the CBOE is relaunching options and futures on GVZ and OVX.  While I like VIX, I think it has some flaws to it that possibly make the product more difficult to use as a hedge:

1.  If the market has a large realized move UP, VIX futures may not hedge properly
2. VIX cash has issues with SPX skew that can cause the product to place more emphasis on puts than calls
3.  The IV of the options is SKY high relative to realized volatility (see chart below)

Livevol (R) www.livevol.com

While I still expect OVX options to have a substantial risk premium relative to the movement in the index, I think the product may do a better job of hedging USO than VIX does of SPX.  Here is why:

For starters, the way USO IV moves.  Like the SPX, generally speaking, if USO is moving in the direction of fear, its IV is going to rally hard.  Unlike SPX, if USO is moving away from the direction of fear, it will also see its IV blip up.  This means, if one buys an OVX future, call option or put option and the ETF experiences a large move in either direction, that derivative is likely to pay out.  For USO premium sellers, the OVX should be a dream come true.  Traders will be able to sell option premium, be short gamma, and get a hedge against that short gamma from the OVX options or future. 

In terms of the IV of OVX options as OVX moves less than VIX.  It has a realized volatility of about 40%

Livevol (r) www.livevol.com

I would expect ATM option IV to be around 45-50% when the product opens.  If the IV is much higher than I think, the options are a bit of a sale.  The SKEW will likely be the same standard forward skew as normal oil contracts or a VIX contract.  I would also expect OVX to have a flatter term structure than VIX.  If ‘vol of vol is lower’, so should be the term structure.

While all of the above sounds great, there is one issue I have with this product, the underlying.  USO is better than it used to be, but not nearly as good as using WTI futures themselves.  IMO, the CME has done nothing with their OVX contract; the CBOE would be better off signing a licensing deal with CME and trading and marketing the OVX contract based on Crude Futures instead of on USO.  The USO ETF is not nearly as efficient at tracking OIL and GLD as SPY is at tracking their perspective indexes.  It is because of this that, despite the idea being great, I think OVX is going to have some problems relative to a GVZ (which should have worked the first time and will eventually be great).

The Trade

In order to hedge using OVX, I think the best trade is going to be owning call spreads.  To get short, despite the forward skew, my guess is short calls will out perform long puts.  It appears that OVX above 40 is a sale, with 50 being  panic time.  Anywhere into the low 20s, and the index is a buy.

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