Entering the Volatility Fray

Traders wishing to trade volatility gained yet another weapon to their arsenal with the CBOE's recent roll out of options on the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). As with any new trading product, I've been watching the trading volumes on both to see what type of traction they gain and whether or not they offer sufficient liquidity to merit a place in my personal trading toolbox. In assessing liquidity I'm primarily interested in whether or not the vehicle under scrutiny offers a tight enough bid-ask spread. If the spreads are wide enough to drive a Mack truck through, I'm not interested. Perhaps we could pin up SPY options as the poster child since they offer super tight penny spreads due their tremendous liquidity.

Given the current status of the VXZ options, I wouldn't touch them with a ten foot pole. With the spreads as wide as they are, why bother? VXX options, on the other hand, are starting to look a bit more tempting. Like most semi-liquid options, the front month is seeing the most action and thus offering the tightest spreads. Currently the ATM June call is trading at $1.95 by $2.15. At $.20, the spread is certainly tight enough to warrant playing with in my opinion. Venturing further along the expiration curve offers less liquidity and wider spreads. I suspect as volume builds, we'll see the spreads continue to come in.

Currently we're seeing a decent amount of upside skew in VXX options, where higher strike calls are trading at higher vol levels than lower strike calls. Those familiar with VIX options shouldn't find this all that revealing as VIX options have historically seen a decent amount of upside vol skew due to the higher demand for OTM calls versus OTM puts. Consider the following skew chart of the VXX July options.

Today marked my first attempt at trading VXX options. To exploit the relative expensiveness of the OTM calls as well as a neutral to bearish move in the underlying, I entered a July call ratio spread by buying a 37 call and selling two 40 calls.

As long as we remain below 37 between now and July expiration, I stand to gain the net credit received at trade inception. A slow drift higher would also prove beneficial provided it doesn't occur too quick. Due to the extra short calls there is upside gamma risk if a continued rise in volatility gets out of hand. But given the already elevated state of volatility futures I'm relatively comfortable placing my bets we don't go

much higher over the next few weeks.

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