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Introduction Several investors expressed interest in trading instruments related to the market's expectation of future volatility, and so VIX futures were introduced in 2004, and VIX options were introduced in 2006. 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. VIX is a great way to hedge your long portfolio. It is a well known fact that during severe market downturns, VIX spikes significantly, which can offset some of your portfolio losses. However, you cannot trade VIX directly. There are few ways to trade VIX: ETFs/ETNs. iPath S&P 500 VIX Short-Term Futures ETN(NYSE:VXX) is just one example. VXX trades first and second month VIX futures. Unfortunately, VXX is not designed to be held beyond very short period of time due to contago loss. Most days both sets of VIX futures that VXX tracks drift lower relative to the VIX—dragging down VXX’s value at the average rate of 4% per month (30% per year). In fact, VXX is probably one of the worst long term investments. VIX futures and Options. Options and futures are investments with a definite lifespan; not only do investors have to be right about the direction of volatility, but also the timeframe. Of course if you buy VIX calls and volatility spikes, you can make some significant gains. But most of the time, those calls will lose money due to the fact that VIX drift lower, and those options will lose value over time. Possible solution: VIX strangle This article describes the following strategy of going long VIX: Purchase VIX put options that expire 3 months out and are 2.5% out of the money and simultaneously buy 4th month call options that are 20% out of the money. These positions are established each month on a date that is half way between the 3rd and 4th month expiration dates. Two months later these option positions are rolled. The put leg of the calendar strangle can help reduce the cost of the long call. Typically, when hedging through purchasing an out of the money call option on VIX to gain protection against tail risk there can be an undesirable carrying cost for the position. In periods of low volatility the long put position will benefit from the term structure of VIX futures pricing as the time to expiration for the option approached expiration. The long call position will be in place to potentially benefit from market conditions that result high higher implied volatility for the market as indicated by VIX. The general idea is that short term futures are declining faster than long term futures, and if VIX stays stable, the put gains will offset the call losses. Basically the strategy will roll the trade every two months. Expected results During calm periods when VIX stays stable or drifts lower, we can expect the trade to produce 10-15% gains or end up around breakeven because the puts gains will offset or slightly outpace the calls losses. However, during periods of volatility spike, the calls should gain significantly, and in some cases, the whole structure can deliver 50-100% gains. This is basically a cheap way to go long VIX and hedge your long portfolio, without experiencing losses during calm periods. We have made several changes to the strategy in order to better adapt to the current market conditions. Related articles VIX - The Fear Index: The Basics VIX Term Structure Top 10 Things To Know About VIX Options Want to see how we implement this strategy in our SteadyOptions model portfolio? Start Your Free Trial
Here are 10 important things about VIX options. VIX options settle in cash and trade in the European style. European style options cannot be exercised until expiration. The options can be opened or closed anytime before expiration. You don’t need to worry about ending up with an unwanted position in VIX after expiration. If your VIX options expire In-The-Money (ITM), you get a cash payout. The payout is the difference between the strike price and the VRO quotation on the expiration day (basically the amount the option is ITM). For example, the payout would be $2.50 if the strike price of your call option strike was $15 and the VRO was $17.50. Expiration Days: VIX options do not expire on the same days as equity options. The Expiration Date (usually a Wednesday) will be identified explicitly in the expiration date of the product. If that Wednesday is a market holiday, the Expiration Date will be on the next business day. On the expiration Wednesday the only SPX options used in the VIX calculation are the ones that expire in 30 days. Last Trading Day for VIX options is the business day prior to the Expiration Date of each contract expiration. When the Last Trading Day is moved because of a Cboe holiday, the Last Trading Day for an expiring VIX option contract will be the day immediately preceding the last regularly scheduled trading day. The exercise-settlement value for VIX options (Ticker: VRO) is a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices during regular trading hours for SPX of the options used to calculate the index on the settlement date. The opening price for any series in which there is no trade shall be the average of that option's bid price and ask price as determined at the opening of trading. Click here for Settlement Information for VIX options. For example: Table courtesy of projectoption.com. Contract Expirations: Up to six 6 weekly expirations and up to 12 standard (monthly) expirations in VIX options may be listed. The 6 weekly expirations shall be for the nearest weekly expirations from the actual listing date and standard (monthly) expirations in VIX options are not counted as part of the maximum six weekly expirations permitted for VIX options. Like the VIX monthlys, VIX weeklys usually expire on Wednesdays. VIX Options Trading Hours are 8:30 a.m. to 3:15 p.m. Central time (Chicago time). Extended hours are 2:00 a.m. to 8:15 a.m. Central time (Chicago time). CBOE extended trading hours for VIX options in 2015. The ability to trade popular VIX options after the close of the market provides traders with a useful alternative, especially from overseas market participants looking to gain exposure to the U.S. market and equity market volatility. VIX options are among of the most actively traded contracts the options market has to offer. VIX options are based on a VIX futures, not the spot index ($VIX) quote. Therefore VIX options prices are based on the VIX futures prices rather than the current cash VIX index. To understand the price action in VIX options, look at VIX futures. This can lead to unusual pricing of some VIX strategies. For example, VIX calendars can trade at negative values. This is something that can never happen with equity options. Hedging with VIX options: VIX can be used as a hedging tool because VIX it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, traders many times would buy of out of the money calls on the VIX as a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs. VIX is a mean-reverting index. Many times, spikes in the VIX do not last and usually drop back to moderate levels soon after. So, unless the expiration date is very near, the market will take into account the mean-reverting nature of the VIX when estimating the forward VIX. Hence, VIX calls are many times heavily discounted whenever the VIX spikes. VIX options time sensitivity: VIX Index is the most sensitive to volatility changes, while VIX futures with further settlement dates are less sensitive. As a result, longer-term options on the VIX are less sensitive to changes implied volatility. For example, between September 2nd and October 10th 2008, the following movements occurred in each volatility product: Product Sep. 02 - Oct. 10 Change VIX Index +218% October VIX Future +148% November VIX Future +67% December VIX Future +47% Table courtesy of projectoption.com. So, while trading long-term options on the VIX might give you more time to be right, volatility will need to experience much more significant fluctuations for your positions to profit. Option Greeks for VIX options (e.g. Implied Volatility, Delta, Gamma, Theta) shown by most brokers are wrong. Options chains are usually based on the VIX index as the underlying security for the options. In reality the appropriate volatility future contract is the underlying. For example, August VIX options are based on August VIX futures, not VIX spot. Related articles: VIX - The Fear Index: The Basics Using VIX Options To Hedge Your Portfolio How Does VIX Work? 10 Things You Should Know About VIX Holiday Effect In VIX Futures