Buyside Strategies EQD Research Quantitative Strategies Volatility

EQD Research: Ready And Waiting For The Next VSTOXX Rally

May 14, 2020

By Russell Rhoads,
head of research

VSTOXX recently reached levels many traders would never have expected to be achieved. Many marveled at how a VSTOXX March 21 call went from 1.00 to over 60.00 in a matter of days. They also participated in the mental, “if I had only known” trade. The issue is that for several expiration cycles the 21 strike (and lower strike) call options expired with no value. This means consistently being long volatility through buying VSTOXX calls would have been costly and frustrating for an extended period. So frustrating that many traders may have given up on being prepared for the next big move from VSTOXX.

Volatility traders are a unique breed and they are always coming up with methods that can take advantage of the consistent overpricing of volatility expectations or inexpensive ways to be prepared for the next volatility event. There is one spread that can do both. Selling a lower strike call and then buying two calls at a higher strike price may benefit from either a slow drift lower in VSTOXX futures or a big move to the upside.

The following is an example of this trade. On June 20, 2017 VSTOXX was at 14.03 and the July VSTOXX future was trading at 15.00. A 1 x 2 spread could be constructed by selling the VSTOXX July 15 call for 1.20 and then purchasing two VSTOXX July 20 calls for 0.45 each. The net result is a spread trade that is initiated with a credit of 0.30. The payoff at July expiration appears in the diagram below.

If held to expiration this trade makes money anywhere below 15.30 or above 24.70. Between those two price levels this trade would result in a loss with the maximum potential loss coming in at 4.70. This maximum loss occurs if July VSTOXX futures and options final settlement price is at 20.00 and the position is held through settlement. In this case the July VSTOXX settlement price was 13.16. This would result in all options expiring out of the money and the trade realizing a profit equal to the credit of 0.30 realized when the trade was executed. A volatility event, such as what occurred in March 2020, would result in a very large profit. Again, that is if a trader chose to hold through settlement.

To determine how effective this sort of trade would be over time we devised a rules-based method of implementing this spread beginning with the January 2018 VSTOXX options continuing through the March 2020 option expiration. The method is straightforward:

On the day before VSTOXX settlement the following month options contracts are traded.

  • The trade is only implemented if spot VSTOXX is at a discount to the future.
  • In the case where spot VSTOXX is greater than the future a trade would be placed the first day that the spot index is lower than the future.
  • A call option with a strike that is equal to or just greater than the corresponding VSTOXX future price is sold.
  • Two call options that are one strike higher than the lowest call strike that would result in a trade being initiated for a credit are purchased.
  • The trade is held through settlement.

The previous example using the July 2017 options followed these rules. June 20, 2017 was the day before June 2017 VSTOXX futures and options settled. The relevant index, option, and future pricing appears in the table below.

Spot VSTOXX, July Future, and Call Option Pricing – June 20, 2017

Data Source: Bloomberg

Spot VSTOXX closed at 14.03 and the July 2017 VSTOXX future closed at 15.00. This is important as the spot index at a discount to the future is typically associated with a normal or low volatility environment. Also, this is useful as in order to profit from the trade when volatility stays low the future should be lower than the strike price of the option sold. Spot VSTOXX at a lower level than the future increases the odds of this being the case at settlement.

Based on the future closing price of 15.00, 1 VSTOXX July 15 call is sold for 1.20. The next step is to determine the call options that will be purchased. For the trade to be initiated at a credit the options purchased should have a premium lower than 0.60. Remember two options are being purchased while one is being sold. The July 19 call is the first option with a cost of less than 0.60. Based on this two VSTOXX July 20 calls would be purchased for 0.45 each or a total cost of 0.90. Combined with the 1.20 credit take in when the July 15 call is sold the result is a credit of 0.30. Both options are highlighted in the pricing table.

As noted, this exercise was repeated for each expiration from January 2018 through March 2020. All hypothetical trades appear in the table below. There are two instances where the trade signal did not appear until a few days after the day before the prior month’s settlement. This was for the March 2018 and June 2019 contracts with the signal not appearing until March 9, 2018 and June 5, 2019. Also, the December 2018 time period is the only instance where the spot VSTOXX index closed at a premium relative to the future every day. Therefore, there was no trade using December 2018 options. A final period to point out relates to the February 2018 contract. There was a move higher in spot VSTOXX and the future that pushed the unrealized gain to over 7.00 points before settling back down with the trade yielding only a 0.81 profit if held through settlement.

Rules Based 1 x 2 Call Spread Statistics – January 2018 to March 2020 Expiration Cycles

Data Sources: Bloomberg, EQDerivatives Calculations

There is a lot of data to digest here so a summary is offered below. There were 27 observations covered by this time period with 26 trade signals. Of those 26 signals there were 21 instances where VSTOXX settlement results in a trade profit. There are three instances where the result is a loss. The worst outcome was a loss of 2.67 associated with the August 2019 contract. The average drawdown for a trade was -0.72 with the worst-case scenario again being a drawdown of -3.00 for the August 2019 contract.

Rules Based 1 x 2 Call Spread Summary Statistics – January 2018 to March 2020 Expiration Cycles

Data Source: Bloomberg, EQDerivatives Calculations

Finally, there were two instances where VSTOXX settlement was high enough that the trade made a profit based on that outcome. The first, already noted, was February 2018, with a net gain of 0.81. The other, was March 2020 with VSTOXX settlement pushing the value of this trade to 62.44. Of course, once VSTOXX and the March future started to move higher, holding onto what was already a big gain would probably been difficult, if not impossible for most traders. Taking a profit of 20 or 30 points at most is probably the more realistic outcome.

As the world starts to reopen and put the current situation behind it the financial markets will return to some normalcy. However, at some point in the future volatility expectations and associated markets like VSTOXX futures and options will reflect elevated expectations. The 1 x 2 call spread using VSTOXX options is a method that can allow traders to wait patiently for that next VSTOXX run to the upside and be prepared to profit from it.