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How VIX Can Stay Flat on a Rally

Submitted by msebastian on Wed, 06/27/2012 - 4:41pm

We have dedicated several blogs to educating our option traders on how the VIX tricks the trader.  We saw this again today.  While the VIX ended up slightly down on the day, by no means was volatility down.  Again, getting more granular and looking at strike prices, we can see that IV was infact up.

Here are the 1320 and 1335 strike prices, yesterday's and today's ATM contracts.

1320

1320.PNG

1335

1335.PNG

livevol (r) www.livevol.com

Notice how in both cases. IV was higher today than it was yesterday.  This was the reason the VIX futures didn't react to any of what was gonig on today.  How does this happen though?  the answer is a curve shift.  I have drawn a graphic below:

vix.png

While the underlying rallies,  the curve itself shifts higher; thus yesterday's ATM IV ends up being about the same as today's ATM IV.  We see the same shift accross the entire curve.  Therefore,  when the VIX switches weightings to a higher strike the IV is still the same.  This produces the anomily of SPX up and VIX unchanged.  It is pretty rare but fascinating to watch develop and can give traders a real insight into what the market is thinking.  In today's case, it was as follows:

"Even though the SPX is up nicely, we are worried about the SCOTUS decision.  We are worried about the Euro Summit, and we are going to buy premium today in spite of the rally."

The Trade:

The market is setting up for a premium blood bath on Monday.  While it will take some guts to do it, if the Euro and SCOTUS decisions go as planned,  with the 4th coming up next week,  the VIX could trade 16% by Tuesday morning.  I would be looking at short vol plays that have a defined risk.

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