Volatility Metric: VIX - VOLI residual

VTS Community,

This is a metric that I've used quite effectively in my trading but for whatever reason it's virtually unknown. Some of the other metrics I've covered in the Volatility Dashboard like contango and roll yield for example will show up in Google searches. Now I'd like to think that I go much deeper into those subjects than the others you'll find, but we can't say they are unknown metrics.

The VIX - VOLI residual though, you won't really find much on this subject. I suspect after my article makes the usual social media rounds that will change, but let's get into it.

I'm going to divide this into two parts because I feel these are the two most practical uses for this metric.

Part 1: As a risk assessment tool

As I pointed out in the original VOLI index article, there is a very subtle difference between the VIX index and the VOLI index. 

• The VIX index uses all SPX options.

• The VOLI index only uses at the money SPY options.

 

Some traders may debate which index is better, as if it's one or the other. Personally I find various uses for both, and they are perhaps especially useful when used in conjunction.

So if we simply subtract the VOLI from the VIX, the residual is representing out of the money activity.

This is a decent representation of the robustness of out of the money options activity, which can give clues as to broad hedging behavior and potential market direction.

VIX - VOLI residual since the launch of VXX on Jan 30, 2009:

 

As you can see in the chart, the VIX - VOLI residual ranges from about +10 to -5 on the extremes. Positive readings are when the VIX is above the VOLI which is typically the case, and negative readings are for when the VIX is below the VOLI.

The long-term mean value is about +2. Now this isn't a direct relationship and it should only ever be used as one part of the larger picture, but generally speaking:

- If VIX - VOLI < 2, this may mean hedging behavior is light and market fear in general is subdued

- If VIX - VOLI > 2, this may mean hedging behavior is elevated, indicating potential risk on the horizon

Let me illustrate this point by showing you what the VIX - VOLI residual metric was showing during some of the most extreme volatility spikes of the recent past. Below is a chart showing the top 25 largest VXX spikes since the ETF launched in January 2009.

 

There's clearly been some very ugly days in the VXX's short history. Now personally, I'm not an investor that tries to maximize performance by chasing big gains. Instead, I maximize performance by reducing drawdowns and managing risk. I'm always devising ways to identify risk as it's developing, in order to exit short volatility trades before the damage is done.

Let's take a look at the VIX - VOLI residual readings for both the day before, and at market close the day of, every one of those ugly crashes in the VXX.

* Red represents values in the top 1/3 of its percentile range, yellow is the middle 1/3, and green is the lower 1/3.

 

Notice a pattern?

There's an awful lot of red in that chart, and there was only 1 day out of 25 occurrences that the VIX - VOLI residual was low the day before a volatility event. 18 out of 25 occurrences showed a percentile ranking in the top 1/3, and many of those in extreme percentile readings above 90%.

The mean percentile ranking was 75%, well above what I would comfortably call statistically significant.

This is when we throw in the standard disclaimer, correlation doesn't imply causation. I'm certainly not saying that every time the VIX - VOLI residual metric is elevated that it manifests in a volatility event. But, there is definitely a high correlation when those events do occur and an elevated VIX - VOLI residual reading.

On its own, I don't think this metric would have traders exiting positions full stop whenever it's elevated. However it can serve as a useful red flag, and when used in conjunction with a few other risk metrics it can absolutely serve as a solid filter in helping avoid taking punishing losses on those extreme down days.

Part 2: Strike selection when options trading

• The VIX index uses all SPX options

• The VOLI index uses only at the money SPY options 

Remember when subtracting the VOLI from the VIX, essentially this cancels out the at the money readings and leaves us with a residual representing out of the money options activity.

Can you see how this might be helpful information to know for a trader selecting the most advantageous option strikes?

Options trading is often a game of inches, or small increments. Every little bit of added efficiency can make a huge difference in the long term results. That's why we pay so much attention to managing things like trade fees. Five or ten dollars here and there may not sound like much, but in the long run when factored over hundreds or even thousands of trades, little things really add up.

Strike selection is the same concept. You may not think it makes much of a difference, but the options trader who consistently selects the cheaper strikes to buy and the more expensive strikes to sell is at a huge advantage. Especially when factored over many transactions and multiple years. The VIX index typically trades above the VOLI, but we're more interested in the magnitude of the residual.

• If the VIX - VOLI residual is significant it's showing that the out of the money strikes are showing elevated volatility, and it may be more efficient to sell the out of the money strikes and buy the at the money strikes.

• If the VIX - VOLI residual is small or even negative it's indicating at the money volatility is relatively high in comparison, and it may be more efficient to sell the at the money strikes and buy the out of the money strikes. 

Let's take a look at a few examples:

 

You all know how much I love my Iron Condors. It's a net short trade that is essentially selling out of the money vertical spreads. Now there's also a very similar options trade that displays all the same characteristics to the Iron Condor with a nearly identical risk profile, but it sells the at the money strikes instead. It's called an Iron Butterfly.

 

Can you see how the VIX - VOLI residual can help us choose which one is more efficient given the current market environment?

• If the VIX - VOLI residual is high, it means out of the money volatility is elevated and that may make the Iron Condor the more efficient trade.

• If the VIX - VOLI residual is low, it means the at the money volatility is elevated and that may make the Iron Butterfly the more efficient trade.

Here's another example. Take a look at the following two trade profiles which are materially very similar trades

Short Straddles sell the at the money strikes:

 

Short Strangles sell the out of the money strikes:

 

So depending on the VIX - VOLI residual and how much the out of the money options are elevated compared to the at the money options, the efficient trader can select the more mathematically advantageous trade. Again you may not think it's a huge difference, 5% or 10% here and there, but over time and multiple transactions that could be a game changer.

It's not just short options either. One of the most challenging aspects within the options trading space is dealing with long volatility (long Vega) trades. They are notoriously difficult to manage because of the decay factor (negative Theta).

Selecting strikes to buy that are temporarily depressed in value based on the VIX - VOLI residual metric can mean when conditions normalize, the long option may gain value even if the price doesn't change. Just a pure volatility adjustment can add some value to the contract as well, turning what is normally a very difficult trade into something with potential.

So I invite you to add the VIX - VOLI residual metric to your list of checks when entering options trades. It's the kind of additional filter that may not be that noticeable up front. However, in the long run when you look back on your trading journal the difference will be clear. Efficient strike selection is an often overlooked skill, and this metric can definitely help in that regard.

Check out the rest of the VTS Volatility Dashboard here