How Does VIX Work?

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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