Volatility Views 133: Skew Inversions and Dynamic Hedges

Volatility Views 133: Skew Inversions and Dynamic Hedges Volatility Review: The week in vol VIX Cash: Most major indices up on the week - volatility returns to Rocktober. High - 23.08, Low - 15.56. VIX Options: A whopping 6.14M contracts total. OTC Volatility: Volker rule and its impact on liquidity. VXST: When is it going to catch fire? Oil/Energy: Strong investment skew, heavy puts activity. Metals: An outlook on gold/silver volatility. Volatility Voicemail: Return of the Don Comment from Don S regarding this listener question - "Let me leave you with this question: Long term which do you think will outperform - dynamically hedged SPY ATM straddle or dynamically hedged VIX straddle? They should be roughly equivalent but clearly they are not." Not sure anyone addressed this in a satisfactory manner.  When you dynamically hedge an ATM straddle (meaning keeping it reasonably delta-neutral throughout), you are making a bet that the implied vol at which you buy or sell the options will turn out to be lower/higher than the actual volatility that the underlying goes on to display during the life of the trade.  So, the first decision to make, which the writer did not address, when he asked about outperformance, is whether he was of a mind to be long or short the straddle.  Naturally, being of sound mind, the only acceptable thing to do is to sell the straddle (!), as, historically, the implieds of the options are virtually always higher than what the realized vol of the underlying turns out to be. So, now that we have decided to sell these straddles and dynamically hedge them, trying to earn the spread between implied and realized vol, the question is, which underlying might provide, on average, the better profit potential.  Typically, SPY implieds average 2-4 percentage points over realized, but, of course, there is great variability in that spread, which even goes negative, ever so briefly, from time to time. Unfortunately, I no longer have access to the comparable numbers for VIX, but, of course, we are now talking about making a bet not on the volatility differential between implieds and realized for an equity index, but rather for implied volatility itself (VIX), which means that the values we are dealing with are much higher (in the 90s, as opposed to in the teens).  Again, I do not have the numbers, but I am guessing that the average spread between what amounts to implied vol of vol and actual vol of vol is somewhat greater than that of those same concepts applied to SPY. Soooo, I am guessing that, for the strategy under discussion, the vehicle of choice would be VIX, and, of course, it goes without saying that the only sane thing to be doing with the straddle would be to sell it.  :-) Perhaps, next show, you would like to throw these ideas out there to see what everyone thinks. Regards,Don   Crystal Ball: More reckless guesses about volatility going forward.