Second Order Volatility...

 TWITTER

Last Friday, Michael Khuow - a contributor to CNBC's 'Options Action' - posted a portfolio hedge trade on Twitter of a July VIX 25/40 call spread with a max profit-to-loss ratio of roughly 6.5x.

https://twitter.com/OptionsAction/status/1380647907603451906?s=20 

https://twitter.com/OptionsAction/status/1380647907603451906?s=20 Let me first say, Michael is a highly intelligent and accomplished professional whom I have a great deal of respect for and hold his opinions in high regard.  However, I happen to disagree with him on this one...

VOLATILITY OF VOLATILITY

Let's start by looking at the underlying in this trade because the VIX is unique.  Here's its roughly three month distribution (duration of our trade) for the last two years...

Clearly, there's an extreme right-tail relative to its mode... this is to be expected and its this feature I believe Michael is trying to exploit as a hedging instrument.

However, over this look-back period, the VIX was above the long the long strike of 25 a little more than 13% of the time and in more than half of those instances, it was also north of the short 40 strike.  

Why is that relevant?

If we can reasonably assume the short 40 call will come into play, the negative gamma will severely limit our upside.  The volatility of the volatility hedge is now working against us... or what an old boss of mine used to call 'second order vol.'

What does this look like?

Here's the trade at expiration, with a clean 6.5x upside-to-downside ratio...

 

 ...but in reality, here's what the payoff looks like at trade inception...

 Here:

        1)  At VIX of $40, the PnL is only $516 - a mere 2.5x upside-to-downside

        2)  Also, IV would also be spiking in this instance so the PnL would be even lower

        3)  It's also important to notice that, as volatility increases, the payoff of this trade increases at a decreasing rate... more negative convexity... that's not what you want in a hedge