I was in the middle of an option mentoring session today when a rather smart option mentoring student asked a rather common question: Why does the VIX fall into the weekend a rally after the weekend. I am not the only one who gets this questions for instance anyone who follows Adam Warner's tweets will get the weekly reminder that the VIX being down on a Friday can mean very little.
So why does the VIX fall into the weekend and rally after. The answer: weekend time decay. We all know that Options decay into the weekend. If you do not, please read 'how options time premium decay's into the weekend.' One of the big problems with the cash VIX that is quoted by every talking head that knows little about options, is that it does not do anything to make up for the weekend affect of options. Thus, the theta decay that comes out of options prior to a weekend or long weekend that can be seen quantifiably in option implied volatility also has an effect on the VIX cash. Here is a simplified example from the Labor Day holiday we just passed.
The VIX attempts to take a look at implied volatility going out 30 days. Thus between last Friday and yesterday the VIX was calculated using a combination of both September options and October options. I am going to use a simplified model and use the number and weight September by the number of days it has till expiration over 30. Then I am going to use the 30 less that number, over 30 to determine the October weighting.
Over the weekend the average number of days till September expiration was 11. So our Sep weighting is going to be 11/30 or .37. Our October weighting will be 19/30 or 63%.
Since we have three days of decay, that we have to decay out of the SPX options we have to reduce the value of these options by the total weekend theta. I will use ATM theta for the number (again over simplified). Our ATM theta for Friday, Saturday, Sunday, and Monday was $2.40 for September. For October, the ATM theta that had to be decayed was 1.62.
Believe it or not it is easy to quantify the affect these options have in SPX IV. All we have to do is divide them by the average vega number on Friday (this is because all of the theta should be seen coming out on that Friday). On Friday the SEP ATM options had a vega .86. The October options had a vega of 1.49. On Friday, IV in September options should have been down by 2.79%. Options for October should have been down by 1.08%. If we look at the IV's on the ATM strikes between Thursday and Friday, it is really close. Thursday's SEP ATM options IV's fell from 19.40% to 17.25% (there was some price movement which will throw the exact numbers off). October fell from 21.10% to 19.9%; this also was affect by Friday’s price movement.
Now let’s weight our IV changes and see how much the VIX should have been down.
SEP (.37*2.79) +OCT (.63*1.08) =1.72%
Thus even if IV hadn't moved, because traders were waiting to price out the weekend until after non-farm payrolls (this is one of the times where weekend affect is crystal clear) the VIX was going to drop almost 2 full percentage points regardless of what IV did. This is all priced back in on Tuesday. Take a quick look at a VIX chart. If we added 1.72 back into Friday’s drop, how much has IV really moved since Friday?
Traders, this weekend effect can be a real problem if you are looking for a better way to track IV, then try either VXX, VXV, or follow the VIX futures (this is the best way in my opinion).
Today:
Today, we hit the lowest real IV level we have seen since the flash crash. I think we have a little further to go, but I would not be afraid to get net long weighted vega. I think traders can hold off on long calendars, condors, and diagonals. I would be trading butterflies with insurance. I am continueing to keep a close eye on SPX Oct-Nov timespreads, I think that trade is about to become very appealing. Keep an eye on that spread. Finally, VIX, VXN and several of the other IV indexes have been flopping back and forth. Stay nimble as one of those trades may also become a decent opportunity. I continue to think we top out around 1110-1120 before heading back below 1040.
I would like to thank Mike from serious options for having me on his webinar series today. It was one of the best interviews I have had. Also, if you are interested in seeing me trade and talk about this kind of stuff every day. Make sure to sign up and attend the LIVE AM PIT Report, every day at 9:50 Eastern.
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