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By Kim
Since its introduction in 1993, the VIX Index has been considered by many to be the world's premier barometer of investor sentiment and market volatility. Several investors expressed interest in trading instruments related to the market's expectation of future volatility, and so VX futures were introduced in 2004, and in 2006 it became possible to trade VIX options.
Options and futures on volatility indexes are available for investors who wish to explore the use of instruments that might have the potential to diversify portfolios in times of market stress.
Much of the information below is taken directly from the CBOE website.
What is VIX Index?
The CBOE Volatility Index® is an up-to-the-minute market estimate of implied (expected) volatility that is calculated by using the midpoint of real-time S&P 500® Index (SPX) option bid/ask quotes. More specifically, the VIX Index is intended to provide an instantaneous measure of how much the market thinks the S&P 500 Index will fluctuate in the 30 days from the time of each tick of the VIX Index.
CBOE calculates the VIX Index using standard SPX options and weekly SPX options that are listed for trading on CBOE. Standard SPX options expire on the third Friday of each month and weekly SPX options expire on all other Fridays. Only SPX options with Friday expirations are used to calculate the VIX Index.*Only SPX options with more than 23 days and less than 37 days to the Friday SPX expiration are used to calculate the VIX Index. These SPX options are then weighted to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
How Do I Trade VIX?
VIX cannot be traded directly. However, traders can trade VIX futures, trade VIX options and also some other VIX related products, like VXX.
Expiration
VIX derivatives generally expire on Wednesday mornings. If that Wednesday or the Friday that is 30 days following that Wednesday is a CBOE holiday, the VIX derivative will expire on the business day immediately preceding that Wednesday.
Last Trading Day
The last trading day for VIX options is on the business day (usually a Tuesday) immediately before expiration. If that day is a CBOE holiday, the last trading day for an expiring VIX option will be the day immediately preceding the last regularly scheduled trading day.
Settlement value
The final settlement value for VIX futures and options is determined on the morning of their expiration date (usually a Wednesday) through a Special Opening Quotation ("SOQ") of the VIX Index using the opening prices of a portfolio of SPX options that expire 30 days later.
VIX Options Pricing
Please note that VIX options prices are based on VIX futures not the VIX spot. The VIX options are European exercise. That means you can’t exercise them until the day they expire. There is no effective limit on how low or high the prices can go on the VIX options until the exercise day. VIX trading hours are: 7:30am to 4:15pm Eastern time.
Practical implications:
Since VIX options are based on VIX futures, they bahave very differently from "regular" options. For example, calendar spread can have negative values - this would never happen with regular calendars.
The Relationship of the SPX and the VIX
The chart below shows the daily closing prices for the S&P 500 and VIX during the third quarter of 2012. The blue line and left scale represent the S&P 500 while the red line and right scale represent VIX. This chart is a typical example of how the S&P 500 and VIX move relative to each other on a daily basis.
The table below examines price behavior from January 1, 2000 to September 28, 2012. During this time period the S&P 500 closed higher on 1692 trading days, and of those days, VIX closed lower on just over 82% of the time. Also, during this period, the SPX closed lower on 1514 trading days, and of those days, VIX closed higher over 78% of the time. Altogether, during the period covered in the table, VIX moved in the opposite direction of the S&P 500 about 80% of the time.
S&P 500 Up
VIX Index Down
Percent Opposite
1692
1390
82.15%
S&P 500 Down
VIX Index UP
Percent Opposite
1514
1187
78.40%
Source: Bloomberg
The conclusion from those tables is simple: VIX usually goes up when SPX goes down, and vice versa. That’s why many investors have (for better or worse) seen an “investment” in VIX as a kind of hedge against market risk.
If you are not a member yet, you can join our forum discussions for answers to all your options questions.
VIX Futures Curve
A futures curve is a curve made by connecting prices of futures contracts of the same underlying, but different expiration dates. It is displayed on a chart where the X axis represents expiration date of a futures contract and the Y axis represents prices. The concept of futures curve is similar to that of yield curve, which is used for bonds or the money market and displays interest rates of different maturities.
VIX futures curve is made of prices of individual VIX futures contracts. The first point (the left end of each curve) on the chart on this page is the spot VIX Index value; the others are futures prices.
Contango vs. Backwardation
When a futures curve is upward sloping from left to right, it is called contango (we say that a market is in contango). In contango, near term VIX futures are cheaper than longer term VIX futures. Contango is very common in VIX futures, especially when the spot the CBOE Volatility Index® is very low. Contango can be interpreted in the way that the futures market expects the VIX (and volatility in general) to rise in the future.
The opposite situation, when near term futures are more expensive and futures curve is downward sloping, is called backwardation. Backwardation is less frequent than contango in VIX futures, but not uncommon. It typically occurs when the spot the CBOE Volatility Index® spikes up (to levels such as 35-40 or more) and the market expects volatility to calm down somehow in the future.
VIX Term Structure (or VIX Futures Term Structure) is also the name frequently used for VIX futures curve.
Conclusion
VIX is a very complicated product. Please make sure you understand how it works before trading it.
Related articles
Using VIX Options To Hedge Your Portfolio VIX Term Structure 10 Things You Should Know About VIX VIX - The Fear Index: The Basics How Does VIX Work? How To Lose $197 Million Trading VIX Top 10 Things To Know About VIX Options
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By Bill Luby
I have had quite a few requests to present some introductory material on the VIX, so with that in mind I offer up the following in question and answer format:
Q: What is the VIX?
A: In brief, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index (SPX) for the next 30 calendar days. The formal name of the VIX is the CBOE Volatility Index.
Q: How is the VIX calculated?
A: The CBOE utilizes a wide variety of strike prices for SPX puts and calls to calculate the VIX. In order to arrive at a 30 day implied volatility value, the calculation blends options expiring on two different dates, with the result being an interpolated implied volatility number. For the record, the CBOE does not use the Black-Scholes option pricing model. Details of the VIX calculations are available from the CBOE in their VIX white paper.
Q: Why should I care about the VIX?
A: There are several reasons to pay attention to the VIX. Most investors who monitor the VIX do so because it provides important information about investor sentiment that can be helpful in evaluating potential market turning points. A smaller group of investors use VIX options and VIX futures to hedge their portfolios; other investors use those same options and futures as well as VIX exchange traded notes (primarily VXX) to speculate on the future direction of the market.
Q: What is the history of the VIX?
A: The VIX was originally launched in 1993, with a slightly different calculation than the one that is currently employed. The ‘original VIX’ (which is still tracked under the ticker VXO) differs from the current VIX in two main respects: it is based on the S&P 100 (OEX) instead of the S&P 500; and it targets at the money options instead of the broad range of strikes utilized by the VIX. The current VIX was reformulated on September 22, 2003, at which time the original VIX was assigned the VXO ticker. VIX futures began trading on March 26, 2004; VIX options followed on February 24, 2006; and two VIX exchange traded notes (VXX and VXZ) were added to the mix on January 30, 2009.
Q: Why is the VIX sometimes called the “fear index”?
A: The CBOE has actively encouraged the use of the VIX as a tool for measuring investor fear in their marketing of the VIX and VIX-related products. As the CBOE puts it, “since volatility often signifies financial turmoil, [the] VIX is often referred to as the ‘investor fear gauge’”. The media has been quick to latch onto the headline value of the VIX as a fear indicator and has helped to reinforce the relationship between the VIX and investor fear.
Q: How does the VIX differ from other measures of volatility?
A: The VIX is the most widely known of a number of volatility indices. The CBOE alone recognizes nine volatility indices, the most popular of which are the VIX, the VXO, the VXN (for the NASDAQ-100 index), and the RVX (for the Russell 2000 small cap index). In addition to volatility indices for US equities, there are volatility indices for foreign equities (VDAX, VSTOXX, VSMI, VX1, MVX, VAEX, VBEL, VCAC, etc.) as well as lesser known volatility indices for other asset classes such as oil, gold and currencies.
Q: What are normal, high and low readings for the VIX?
A: This question is more complicated than it sounds, because some people focus on absolute VIX numbers and some people focus on relative VIX numbers. On an absolute basis, looking at a VIX as reformulated in 2003, but using data reverse engineered going back to 1990, the mean is a little bit over 20, the high is just below 90 and the low is just below 10. Just for fun, using the VXO (original VIX formulation), it is possible to calculate that the VXO peaked at about 172 on Black Monday, October 19, 1987.
Q: Can I trade the VIX?
A: At this time it is not possible to trade the cash or spot VIX directly. The only way to take a position on the VIX is through the use of VIX options and futures or on two VIX ETNs that are based on VIX futures: VXX, which targets VIX futures with 1 month to maturity; and VXZ, which targets 5 months to maturity. An inverse VIX futures ETN, XXV, was launched on 7/19/10. This product targets VIX futures with 1 month to maturity. As of May 2010, options have been available on the VXX and VXZ ETNs.
Q: How can the VIX be used as a hedge?
A: The VIX is appropriate as a hedging tool because it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, portfolio managers often find that buying of out of the money calls on the VIX to be a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs.
Q: How do investors use the VIX to time the market?
A: This is a subject for a much larger space, but in general, the VIX tends to trend in the very short-term, mean-revert over the short to intermediate term, and move in cycles over a long-term time frame. The devil, of course, is in the details.
Bill Luby is Chief Investment Officer of Luby Asset Management LLC, an investment management company in Tiburon, California. He also publishes the VIX and More blog and an investment newsletter. His research and trading interests focus on volatility, market sentiment, technical analysis, ETPs and options. Bill was previously a business strategy consultant. You can follow Bill Twitter. This article was originally published here.
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By Kim
VXX History
Jill Malandrino, formerly of TheStreet.com writes it beautifully when she notes:
To see how often VIX futures are in contango, or more precisely, how often VXX falls, here is an all-time price chart for trading VXX options:
Yep, the VXX is down 99.96% since inception. The reason is simply that VIX is almost always in contango. For the times that VIX falls out of contango, we can see abrupt pops in the VXX which we have highlighted in the image above.
The Incredible Option Trade In VXX
in 2017, Ophir Gottlieb from CMLviz Trade Machine tested buying a put option spread in the VXX using the 90 day options over the last five-years. Here are the results of this VXX options trading strategy:
Tap Here to See the back-test
We see a 615% return, testing this over the last 5-years. Since we tested the 90 day options, that was 21 trades, in which 17 were winners and 4 were losers.
In fact, this strategy would be a winner every single year in 2010-2017.
2018 was very different
2018 was a very different year in many areas. In fact, 2018 was a first positive year for VXX since inception:
We tested the same VXX strategy in 2018. Here are the results:
Tap Here to See the back-test
That's right, for the first time since 2010, this strategy would produce negative returns. Which is not surprising, considering VXX was up 73.5% in 2018.
In fact, some periods in 2018 (specifically February and December) were so brutal that some funds blew up their clients account. The Spectacular Fall Of LJM Preservation And Growth describes one of those funds. Some of those funds were in business for over 20 years, but when volatility went through the roof in February, it was too much for them.
How to do it the right way
The way to create more consistent returns shorting volatility is to utilize spreads to hedge your position. At the simplest level, this modestly reduces profit potential but dramatically reduces loss potential. Even under the hedged scenario we can still create a 1:1 Risk:Reward on a trade that wins about 75% of the time. The key is when that wave of massive volatility hits the market seemingly overnight, we are dealing with a manageable loss rather than something catastrophic as one would expect in the unhedged scenario.
There are times when extreme volatility will give solid opportunity to short volatility unhedged, but it should always be done with a very small allocation. Patience and experience is also key with regard to entering, adjusting and exiting positions. In addition there are times when things get so out of touch with reality that the best course of action is to simply sit out for a bit and let the dust settle. It is likely that the most successful volatility traders use a combination of discretionary and systematic strategies in their trading.
Our PureVolatility portfolio (which is part of Creating Alpha service) produced double digit returns in 2018 during a first positive year for VXX since inception. Considering the overall market environment, this is an incredible performance.
The Incredible Winning Trade In SVXY describes one example of how the strategy performed in February when VIX doubled in a single day. Overall this trade produced almost 45% gain on margin or 26% gain on $10,000 portfolio.
A trade that was long SVXY, was a big winner after SVXY went down 90%+. This is options trading at its best. And this is the power of our trading community.
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By Kim
According to the story, the trader has consistently purchased bite-sized chunks - usually costing around 50 cents - of VIX options contracts betting on a spike in the CBOE Volatility Index. Also known as the VIX, the gauge is a measure of expected price swings in US equities that serves as a barometer for investor nervousness. It generally climbs as stocks fall, so purchases of VIX contracts translate to bearish wagers on the S&P 500.
On a year-to-date basis, that persistence has resulted in a whopping $197 million mark-to-market loss for 50 Cent, according to data compiled by Macro Risk Advisors (MRA). The firm reports that the trader has spent a total of $208 million on VIX bets, only to see the majority of them expire worthless.
Despite the dogged effort exhibited throughout 2017, 50 Cent seems to be losing steam. After reaching a maximum outstanding position of more than 1 million contracts over the summer, the infamous volatility vigilante currently only has about 200,000 in play, MRA says.
Background
The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Considered by many a "Fear Index", the VIX represents one measure of the market's expectation of stock market volatility over the next 30-day period.
VIX cannot be traded directly. However, traders can trade VIX futures and VIX options and also some other VIX related products, like VXX.
So what you can do when you believe VIX is cheap? You can buy some calls or call spreads on VIX futures, betting that VIX will go up. After all, when VIX is at 10-11, how much lower can it go?
Here is the problem: since you buy options on VIX futures, not VIX, those futures will usually be priced higher than the spot. If the spot is 11, the futures can still trade around 13-14 or even higher. However, over time, if VIX is stable, the future will drift lower, causing those calls or call spreads to slowly bleed money.
This is exactly what happened to 50 cent trader.
To be fair, 2017 was a very challenging year for volatility traders. VIX stayed at historically low levels much longer than anyone could reasonably predict (see the chart above). It spent most of the year around 10-11 levels. This is unprecedented. Trades that worked very well in previous years stopped working in 2017. This is why it is so important to adapt to continuously changing market conditions and not stay stagnant.
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By Kim
I have been considering this trade for a while. Then I came across this article - http://seekingalpha....vix-for-dummies
The thesis is:
Rather than just selling naked PUTS on VIX, when VIX is somewhat higher and shows signs of contango, a calendar spread can be effective. The best way to notice this is if the premiums on PUTS are very close, even as the expiry increases. For instance, both the January 2013 and February 2013 16 strike PUT have a bid/ask of $1.05/$1.15. This equalization doesn't exist with normal options, but as I said, VIX options are "strange." When this occurs, I look to sell the January 16 strike PUT for a credit of $1.05, and buy the February 16 strike PUT for a debit of $1.15. Total cost is a debit of 10 cents.
So if VIX rises above 16, the January 16 strike premium of $1.05 is fully earned. If the February strike is worth more than 10 cents, profit ensues. Unless VIX goes way, way, way up, gain is a very likely outcome.
I did some backtesting and it shows excellent results. I would like to make few small adjustments
1. rather than 16 strike, I noticed that doing the 17 strikes produces better results
2. Instead of doing February/January, I want to do March/January, so I can roll the short options to February after one month. Currently the trade can be done for about 10 cents credit.
Remember that VIX calendar has margin requirement. IB requires $150 per spread. So if you allocate 10% per trade, you will do ~6-7 spreads per 10k portfolio. We aim to make 15-20% return on margin within 3-4 weeks ($25-30 per spread) with fairly low risk.
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By Crazy ayzo
Kim,
I was half way through reading all the VXX material on the site last week when the market went crazy.
I bought 30 OTM put contracts last week when Volatility spiked. It's only been a few days and I'm up nearly 100%... killer return for a few days.
My thesis when I was making the purchase was that the common wisdom expects the markets to stabilize after the midterm elections. Following the template of your earnings call trades, I picked the expiration for two weeks plus a few days beyond the event.
If I'm right, and VXX returns to the high 20's... I make a fortune. This trade seemed too easy. I've read and re-read all the training this weekend. Is there something about VXX options that I'm not grasping that's radically different than stock options?
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By Michael Lebowitz
In the first 18 trading days of 2018, the S&P 500 set 14 record highs and amassed a generous 7.50% return for the year.
As quoted, CNBC and most other financial media outlets were exuberant over the prospects for further gains. Wall Street analysts fell right in line. Despite the fact it was not even February, some Wall Street banks were furiously revising their year-end S&P 500 forecasts higher.
On January 27th, the S&P 500 closed down 0.70%, and in less than three weeks, the index fell over 10% from the January 26th high. Very few investors harbored any concern that the rare down day on the 27th was the first in a string of losses that would more than erase 2018’s gains to that point.
Looking back at the January swoon, there were a few indicators that CNBC, others in the media, and those on Wall Street failed to notice. In mid-January, we noticed an anomaly which proved to be a strong leading indicator of what was ultimately to transpire.The purpose of this article is tore-introduce you to this indicator,as it may once again prove helpful. We’ll also remind you why ignoring media and Wall Street driven hype is important.
VIX
VIX is the abbreviation for the Chicago Board of Options Exchange (CBOE) Volatility Index, which gauges the amount of implied volatility in the S&P 500 as measured by pricing in the equity options market.
When optimism runs high, investors tend toseek less downsideprotection and as such VIX tends to decline. Conversely, when markets are more fearful of the downside, VIX tends to rise as investors are willing to pay higher prices for protection via the options market. While not a hard and fast rule, VIX tends to be elevated in down markets and subdued in bullish markets. This historical relationship is shown below. The beigerectangleshighlight recent market drawdowns and the accompanying VIX spikes.
Data Courtesy Bloomberg
Another way to show the relationship is with a scatter plot. Each dot in the plot below represents the percentage change in VIX and the associated percentage change in the S&P 500 for the prior 20 days. The data goes back to 2003. While there are outliers, the graph generally illustrates an inverse relationship, whereby a higher VIX is associated with lower S&P returns and vice versa.
Data Courtesy Bloomberg
January 10th-26th
With an understanding of volatility and its general relationship with marketdirection, we return to the 12 trading days leading up January 27th. The graph below charts the VIX index and the S&P 500 from January 1st to the 26th.
Data Courtesy Bloomberg
The obvious takeaway is that the VIX and the S&P rose in unison. Despite a euphoric financial media, daily record highs and a strong upward trend,investors were increasingly demanding insurance in the options markets.
The scatter plot and its trend lines below show this divergence from the norm.The orange dots represent the daily VIX and S&P changes from the 10th to the 26th while the blue dots represent every trading day from January 1, 2017, thru August 2018.
Data Courtesy Bloomberg
From January 27, 2018 to early March, the VIX was trading over 20, twice the general level that prevailed in early January and throughout most of 2017. The elevated VIX and weak market resulted in a normalization of the typical inverse relationship between volatility and equity performance,and it has stayed normal ever since. The green dots and green trend line in the graph below represent data since January 27th. The divergence and normalization can best seen by comparing the trend lines of each respective period.
Data Courtesy Bloomberg
Tracking VIX
In addition to identifying the relationship as we did in January, we must monitor this relationship going forward. We show two additional metrics for VIX and S&P 500 below that we created to alert us if the typical inverse relationship changes.
Running Correlation: Calculates the correlation between the VIX and the S&P 500 on a rolling 10-day basis. The highlighted area on the line graph below shows the departure from the norm that occurred in mid-January. Anomaly Count: Counts the number of days in a period in which the S&P was higher by a certain percentage and the VIX rose. In the second chart below,the blue bars represent the number of trading days out of the past 20 days when the S&P 500 rose by more than .50% and the VIX was higher.
Data Courtesy Bloomberg
Data Courtesy Bloomberg
Summary
Markets do not suddenly drop without providing hints. As we discussed in our article 1987, the devastating Black Monday 22.60% rout was preceded by many clues that investors were unaware of or, more likely, simply chose to ignore.
Currently, most technical indicators are flashing bullish signals. Conversely, most measures of valuation point to the risk of a major drawdown. This stark contrast demands our attention and vigilance in looking for any data that can provide further guidance. The VIX is just one of many technical tools investors can use to look for signals. We have little doubt that, when this bull market finally succumbs to overvaluation and the burden of imposing levels of debt, clues will emerge that will help us anticipate those changes and manage risk appropriately.
Michael Lebowitz, CFA is an Investment Analyst and Portfolio Manager for Clarity Financial, LLC specializing in macroeconomic research, valuations, asset allocation, and risk management. Michael has over 25 years of financial markets experience. In this time he has managed $50 billion+ institutional portfolios as well as sub $1 million individual portfolios. Michael is a partner at Real Investment Advice and RIA Pro Contributing Editor and Research Director. Co-founder of 720 Global. You can follow Michael on Twitter. This article is used here with permission and originally appeared here.
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By Kim
VIX’s value
The VIX is based on option prices of the S&P 500 index (SPX). One component in the price of SPX options is an estimate of how volatile the S&P 500 will be between now and the option’s expiration date.
The CBOE’s approach combines the prices of many different SPX options to come up with an aggregate value of volatility. Their approach has some advantages.
The current VIX concept is about the expectation of stock market volatility in the near future. The current VIX index value quotes the expected annualized change in the S&P 500 index over the next 30 days, as computed from the current options-market prices.
What does the number mean?
For those interested in what the number mathematically represents, here it is in the most simple of terms. The VIX represents the S&P 500 index +/- percentage move, annualized for one standard deviation. Example, if the VIX is currently at 15. That means, based on the option premiums in the S&P 500 index, the S&P is expected to stay with in a +/- 15% range over 1 year, 68% of the time (which represents one standard deviation).
What does VIX track?
VIX tracks prices on the SPX options market. The SPX options market is big, with a notional value greater than $100 billion, and is dominated by institutional investors. A single SPX put or call option has the leverage of around $200K in stock value.
In general option premiums have inverse correlation to the market. In a rising market, stocks tend to be less volatile and option premiums low which causes lower VIX values. Declining markets are volatile (the old saying is that the market takes the stairs up and the elevator down) and option premiums increase. Much of this increase occurs when worried investors pay a large premium on puts to protect their positions.
While S&P 500 option premiums generally move opposite to the S&P 500 itself they sometimes go their own way. For example, if the market has been on a long bull run without a significant pullback, institutional investors can become increasingly concerned that a correction is overdue and start bidding up the price of puts—leading to a rising VIX in spite of a rising S&P. Historically 20% of the time the VIX moves in the same direction as the S&P 500—so please don’t claim the VIX is “broken” when you see the two markets move in tandem.
The daily percentage moves of the VIX tend to be around 4 times the percentage moves of the S&P 500, but unlike the stock market, the VIX stays within a fairly limited range. The all-time intraday high is 89.53 (recorded on Oct.24 2008) and the all-time intraday low is 9.39 (recorded on Dec.15 2006) with the current methodology. It’s unlikely that the VIX will go much below 9 because option market makers won’t receive enough premium to make it worth their risk. At the high-end things go could go higher (if the VIX had been available in the October 1987 crash it would have peaked around 120), but at some point investors refuse to pay the premium and switch to alternatives (e.g., just selling their positions if they can).
How does VIX trade?
There is no way to directly buy or sell the VIX index. The CBOE offers VIX options, but they follow the CBOE’s VIX Futures of the same expiration date, not the VIX index itself. VIX futures usually trade at a significant premium to the VIX. The only time they reliably come close to the VIX is at expiration, but even then they can settle up to +-5% different from the VIX level at the time.
There are around 25 volatility Exchange Traded Products (ETPs) that allow you to go long, short, or shades in-between on volatility, but none of them do a good job of matching the VIX over any span of time.
The most popular VIX related products are: iPath S&P 500 VIX Short-Term Futures ETN (ARCA:VXX), iPath S&P 500 VIX Mid-Term Futures ETN (ARCA:VXZ), iPath Inverse S&P 500 VIX Short-Term ETN (ARCA:XXV).
VIX-related ETPs can be used to trade long and short, to hedge, to manage risk etc. There are a wide range of VIX-related ETPs on the market, including pure VIX futures-linked products, that can be long, leveraged long, or inverse.
VIX Futures
This is as close to a pure play as you will get, and it's what all the other instruments revolve around. The most important thing to understand: VIX futures don't track the spot VIX on a 1:1 basis.
VIX futures are an estimate where the VIX will be at a certain date, not where the VIX is right now. This is what is called a "forward" contract.
The VIX futures have their own kind of supply and demand and it reflects the expectation of where the VIX will be around the settlement date of that particular future.
VIX futures have a cash settlement. As we get closer to the settlement, the spot VIX and futures price will converge. but until then the market will attempt to guess where the VIX will be by a forward date.
VIX Options
VIX options do not trade based off the spot VIX. Instead the underlying is based off the forward expectation of where the VIX will be. Eventually, the spot VIX and the forward readings will converge as expiration closes in, but for the most part there will be a difference in the two values.
VIX options have a cash settlement-- meaning if you are short in the money options, you can't get assigned any VIX stock. Instead you will have cash pulled out of your account that is the difference between the strike of your short option and the settlement quote for the VIX.
The settlement value is called the Special Opening Quotation (SOQ). This value is based off the opening prices of SPX options. This means that you may think your short VIX options will be out of the money at expiration, but you can find yourself with a not-so-fun surprise if the SOQ runs against you because somebody decided to buy a ton of SPX options. We recommend never to hold VIX options into settlement to avoid nasty surprises.
The Bottom Line
VIX is complicated, you can’t directly trade it, and it’s not useful for predicting future moves of the market. In spite of that, the investment community has adopted it, both as a useful second opinion on the markets, and as the backbone for a growing suite of volatility based products.
If investors really want to place bets on equity market volatility or use them as hedges, the VIX-related ETF and ETN products are acceptable but highly-flawed instruments. They certainly have a strong convenience aspect to them, as they trade like any other stock. That said, investors looking to really play the volatility game should consider actual VIX options and futures, as well as more advanced options strategies like straddles and strangles on the S&P 500.
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By GavinMcMaster
I will explain what option volatility is and why it’s important. I’ll also discuss the difference between historical volatility and implied volatility and how you can use this in your trading, including examples. I’ll then look at some of the main options trading strategies and how rising and falling volatility will affect them. This discussion will give you a detailed understanding of how you can use volatility in your trading.
OPTION TRADING VOLATILITY EXPLAINED
Option volatility is a key concept for option traders and even if you are a beginner, you should try to have at least a basic understanding. Option volatility is reflected by the Greek symbol Vega which is defined as the amount that the price of an option changes compared to a 1% change in volatility. In other words, an options Vega is a measure of the impact of changes in the underlying volatility on the option price. All else being equal (no movement in share price, interest rates and no passage of time), option prices will increase if there is an increase in volatility and decrease if there is a decrease in volatility. Therefore, it stands to reason that buyers of options (those that are long either calls or puts), will benefit from increased volatility and sellers will benefit from decreased volatility. The same can be said for spreads, debit spreads (trades where you pay to place the trade) will benefit from increased volatility while credit spreads (you receive money after placing the trade) will benefit from decreased volatility.
Here is a theoretical example to demonstrate the idea. Let’s look at a stock priced at 50. Consider a 6-month call option with a strike price of 50:
If the implied volatility is 90, the option price is $12.50
If the implied volatility is 50, the option price is $7.25
If the implied volatility is 30, the option price is $4.50
This shows you that, the higher the implied volatility, the higher the option price.Below you can see three screen shots reflecting a simple at-the-money long call with 3 different levels of volatility.
The first picture shows the call as it is now, with no change in volatility. You can see that the current breakeven with 67 days to expiry is 117.74 (current SPY price) and if the stock rose today to 120, you would have $120.63 in profit.
The second picture shows the call same call but with a 50% increase in volatility (this is an extreme example to demonstrate my point). You can see that the current breakeven with 67 days to expiry is now 95.34 and if the stock rose today to 120, you would have $1,125.22 in profit.
The third picture shows the call same call but with a 20% decrease in volatility. You can see that the current breakeven with 67 days to expiry is now 123.86 and if the stock rose today to 120, you would have a loss of $279.99.
WHY IS IT IMPORTANT?
One of the main reasons for needing to understand option volatility, is that it will allow you to evaluate whether options are cheap or expensive by comparing Implied Volatility (IV) to Historical Volatility (HV).
Below is an example of the historical volatility and implied volatility for AAPL. This data you can get for free very easily from www.ivolatility.com. You can see that at the time, AAPL’s Historical Volatility was between 25-30% for the last 10-30 days and the current level of Implied Volatility is around 35%. This shows you that traders were expecting big moves in AAPL going into August 2011. You can also see that the current levels of IV, are much closer to the 52 week high than the 52 week low. This indicates that this was potentially a good time to look at strategies that benefit from a fall in IV.
Here we are looking at this same information shown graphically. You can see there was a huge spike in mid-October 2010. This coincided with a 6% drop in AAPL stock price. Drops like this cause investors to become fearful and this heightened level of fear is a great chance for options traders to pick up extra premium via net selling strategies such as credit spreads. Or, if you were a holder of AAPL stock, you could use the volatility spike as a good time to sell some covered calls and pick up more income than you usually would for this strategy. Generally when you see IV spikes like this, they are short lived, but be aware that things can and do get worse, such as in 2008, so don’t just assume that volatility will return to normal levels within a few days or weeks.
Every option strategy has an associated Greek value known as Vega, or position Vega. Therefore, as implied volatility levels change, there will be an impact on the strategy performance. Positive Vega strategies (like long puts and calls, backspreads and long strangles/straddles) do best when implied volatility levels rise. Negative Vega strategies (like short puts and calls, ratio spreads and short strangles/ straddles) do best when implied volatility levels fall. Clearly, knowing where implied volatility levels are and where they are likely to go after you’ve placed a trade can make all the difference in the outcome of strategy.
HISTORICAL VOLATILITY AND IMPLIED VOLATILITY
We know Historical Volatility is calculated by measuring the stocks past price movements. It is a known figure as it is based on past data. I want go into the details of how to calculate HV, as it is very easy to do in excel. The data is readily available for you in any case, so you generally will not need to calculate it yourself. The main point you need to know here is that, in general stocks that have had large price swings in the past will have high levels of Historical Volatility. As options traders, we are more interested in how volatile a stock is likely to be during the duration of our trade. Historical Volatility will give some guide to how volatile a stock is, but that is no way to predict future volatility. The best we can do is estimate it and this is where Implied Vol comes in.
– Implied Volatility is an estimate, made by professional traders and market makers of the future volatility of a stock. It is a key input in options pricing models.
– The Black Scholes model is the most popular pricing model, and while I won’t go into the calculation in detail here, it is based on certain inputs, of which Vega is the most subjective (as future volatility cannot be known) and therefore, gives us the greatest chance to exploit our view of Vega compared to other traders.
– Implied Volatility takes into account any events that are known to be occurring during the lifetime of the option that may have a significant impact on the price of the underlying stock. This could include and earnings announcement or the release of drug trial results for a pharmaceutical company. The current state of the general market is also incorporated in Implied Vol. If markets are calm, volatility estimates are low, but during times of market stress volatility estimates will be raised. One very simple way to keep an eye on the general market levels of volatility is to monitor the VIX Index.
HOW TO TAKE ADVANTAGE BY TRADING IMPLIED VOLATILITY
The way I like to take advantage by trading implied volatility is through Iron Condors. With this trade you are selling an OTM Call and an OTM Put and buying a Call further out on the upside and buying a put further out on the downside. Let’s look at an example and assume we place the following trade today (Oct 14,2011):
Sell 10 Nov 110 SPY Puts @ 1.16
Buy 10 Nov 105 SPY Puts @ 0.71
Sell 10 Nov 125 SPY Calls @ 2.13
Buy 10 Nov 130 SPY Calls @ 0.56
For this trade, we would receive a net credit of $2,020 and this would be the profit on the trade if SPY finishes between 110 and 125 at expiry. We would also profit from this trade if (all else being equal), implied volatility falls.
The first picture is the payoff diagram for the trade mentioned above straight after it was placed. Notice how we are short Vega of -80.53. This means, the net position will benefit from a fall in Implied Vol.
The second picture shows what the payoff diagram would look like if there was a 50% drop in Implied vol. This is a fairly extreme example I know, but it demonstrates the point.
The CBOE Market Volatility Index or “The VIX” as it is more commonly referred is the best measure of general market volatility. It is sometimes also referred as the Fear Index as it is a proxy for the level of fear in the market. When the VIX is high, there is a lot of fear in the market, when the VIX is low, it can indicate that market participants are complacent. As option traders, we can monitor the VIX and use it to help us in our trading decisions. Watch the video below to find out more.There are a number of other strategies you can when trading implied volatility, but Iron condors are by far my favorite strategy to take advantage of high levels of implied vol.
I hope you found this information useful. Let me know in the comments below what you favorite strategy is for trading implied volatility.
Here’s to your success!
The following video explains some of the ideas discussed above in more detail.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter. The original article can be found here. -
By Bill Luby
The “holiday effect" is the tendency of the CBOE Volatility Index (VIX) December futures to trade at a discount to the midpoint of the VIX November and January futures.
This article provides some historical analysis of the holiday effect and analyzes how the holiday effect has been manifest and evolved over the course of the past few years.
Background and Context on the Holiday Effect on the VIX Index
Part of the explanation for the holiday effect is embedded in the historical record. For instance, in eight of the last twenty years, the VIX index has made its annual low during the month of December. In fact, the VIX has demonstrated a marked tendency to decline steadily for the first 17 trading days of the month, as shown below in Figure 1, which uses normalized VIX December data to compare all VIX values for each trading day dating back to 1990. Not surprisingly, those 17 trading days neatly coincide with the typical number of December trading days in advance of the Christmas holiday.
{Figure 1: The Composite December VIX Index, 1990-2011 (source: CBOE Futures Exchange, VIX and More)}
Readers should also note that, on average, the steepest decline in the VIX usually occurs from the middle of the month right up to the Christmas holiday.
The December VIX Futures Angle
Most VIX traders are aware of the tendency of implied volatility in general and the VIX in particular to decline in December. As a result, since the launch of VIX futures in 2004, there has usually been a noticeable dip in the VIX futures term structure curve for the month of December. Figure 2 below is a snapshot of the VIX futures curve from September 12, 2012. Here I have added a dotted black line to show what a linear interpolation of the December VIX futures would look like, with the green line showing the 0.50 point differential between the actual December VIX futures settlement value of 20.40 on that date and the 20.90 interpolated value, which is derived from the November and January VIX futures contracts. (Apart from the distortions present in the December VIX futures, a linear interpolation utilizing the first and third month VIX futures normally provides an excellent estimate of the value of the second month VIX futures.)
{Figure 2: VIX Futures Curve from September 12, 2012 Showing Holiday Effect (source: CBOE Futures Exchange, VIX and More)}
Looking at the full record of historical data, the mean holiday effect for all days in which the November, December and January futures traded is 1.87%, which means that the December VIX futures have been, on average, 1.87% lower than the value predicted by a linear interpolation of the November and January VIX futures. Further analysis reveals that on 91% of all trading days, the December VIX futures are lower than their November-January interpolated value. The holiday effect, therefore, is persistent and substantial.
The History of the Holiday Effect in the December VIX Futures
Determining whether the holiday effect is statistically significant is a more daunting task, as there are only six holiday seasons from which one can derive meaningful VIX futures data. Figure 3 shows the monthly average VIX December futures (solid blue line) as well as the midpoint of the November and the January VIX futures (dotted red line) for each month since the VIX futures consecutive contracts were launched in October 2006. Here the green bars represent the magnitude of the holiday effect expressed in percentage terms, with the sign inverted (i.e., a +2% holiday effect means that the VIX December futures would be 2% below the interpolated value derived from November and January futures.)
{Figure 3: VIX December Futures Holiday Effect, 2006-2012 (source: CBOE Futures Exchange, VIX and More)}
Conclusions
With limited data from which to draw conclusions, it is tempting to eyeball the data and look for emerging patterns which may repeat in the future. Clearly one pattern is that an elevated or rising VIX appears to coincide with a larger magnitude holiday effect, whereas a depressed or falling VIX is consistent with a smaller holiday effect. The data is much less compelling when one tries to determine whether the time remaining until the holiday season has an influence on the magnitude of the holiday effect. While one might expect the holiday effect to become magnified later in the season, the evidence to support this hypothesis is scant at this stage.
To sum up, investors have readily accepted that a lower VIX is warranted for December and the downward blip in December for the VIX futures term structure reflects this thinking. As far as whether this seasonal anomaly is tradable, there is still a limited amount of data – not to mention some highly unusual volatility years – from which to develop and back test a robust VIX futures strategy designed to capture the holiday effect.
In terms of trading the holiday effect for the remainder of the year, the coming holiday season is also complicated by matters such as the fiscal cliff deadline and various euro zone milestones that are set for early 2013. In fact, there may not be a reasonable equivalent since the Y2K fears in late 1999 that turned out to be a volatility non-event when the calendar flipped to 2000.
While the opportunities to capitalize on the 2012 holiday effect may be difficult to pinpoint and fleeting, all investors should be attuned to seasonal volatility cycles as 2013 unfolds and volatility expectations ebb and flow with the news cycle as well as the calendar.
Bill Luby is Chief Investment Officer of Luby Asset Management LLC, an investment management company in Tiburon, California. He also publishes the VIX and More blog and an investment newsletter. His research and trading interests focus on volatility, market sentiment, technical analysis, ETPs and options. Bill was previously a business strategy consultant. You can follow Bill Twitter. This article is used here with permission and originally appeared here.
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