Trading volatility is nothing new for options traders. After all, most of them rely heavily on volatility information to choose their trades. The Chicago Board Options Exchange (CBOE) Volatility Index, with its ticker symbol VIX, has been popular among traders since its introduction in 1993.
Option traders once used regular equity or index options to trade volatility, but many quickly realized that was not ideal. On Feb. 24, 2006, the CBOE rolled out the VIX options, giving investors more direct access to volatility. In this article, we take a look at the past performance of the VIX and discuss the advantages offered by VIX options.
- On Feb. 24, 2006, the CBOE rolled out the VIX options, giving investors more direct access to volatility.
- The VIX is an implied volatility index that measures the market's expectation of 30-day S&P 500 volatility implicit in the prices of near-term S&P options.
- Buying VIX calls might be an even better hedge against drops in the S&P 500 than buying SPX puts.
- A fixed trading range and high volatility also help make VIX options useful to speculators.
What Is the VIX?
The VIX is an implied volatility index. It measures the market's expectation of 30-day S&P 500 volatility implicit in the prices of near-term S&P options. VIX options give traders a way to trade volatility without needing to consider other factors usually involved in options pricing. These complicating factors typically include price changes in the underlying securities, dividends, and interest rates. VIX options allow traders to focus almost exclusively on trading volatility.
Traders have found the VIX very useful in trading, but it now provides superb opportunities for both hedging and speculation. VIX may also be an excellent tool in the quest for portfolio diversification. Diversification, which most investors find highly desirable, is useful only if the securities selected are not correlated. In other words, if you own ten big tech stocks that tend to move together, then you aren't really diversified.
One advantage of the VIX is that it has a negative correlation with the S&P 500. According to the CBOE's website, the VIX has moved opposite the S&P 500 Index (SPX) 88% of the time since 1990. On average, VIX has risen 16.8% on days when SPX fell 3% or more. This negative relationship makes it an excellent diversification tool and perhaps the best market disaster insurance.
Buying VIX calls might be an even better hedge against drops in the S&P 500 than buying SPX puts. The chart in Figure 1 shows how the VIX moves in the opposite direction of the SPX on its big moves down. The VIX reached a closing high of 80.86 during the 2008 financial crisis. That record stood for over a decade. However, the VIX reached a new record high close of 82.69 during the bear market of 2020.
As you can see in Figure 1, the VIX trades within a given range. It bottoms out around 10. If it were to go to zero, it would mean that the expectation was for no daily movement in the SPX. On the other hand, the VIX spiked upward to above 80 when the SPX crashed. However, the VIX cannot stay there either. A consistently high VIX would imply that the market expectation was for substantial changes over an extended time frame.
A fixed trading range means that VIX options offer excellent opportunities for speculation. Buying calls, buying bull call spreads, or selling bull put spreads when the VIX bottoms out can help a trader capitalize on moves up in volatility, or down in the S&P 500. Similarly, buying puts, buying bear put spreads, or selling bear call spreads can help a trader profit when VIX tops out.
Another factor enhancing the effectiveness of VIX options for speculators is their volatility. According to the CBOE, the volatility for the VIX itself was more than 80% for 2005. That compares with about 10% for SPX, 14% for the Nasdaq 100 Index (NDX), and about 32% for Google.
Despite their advantages for speculators, VIX options are high-risk investments and should play a relatively small role in most portfolios.
However, the value of the options is not derived directly from the "spot" VIX. Instead, it is based on the forward value using current and next month options. The volatility for the forward VIX is lower than that of the spot VIX (about 46% for 2005). However, it still offers higher volatility than most other stock options available to investors. An instrument that trades within a range, cannot go to zero, and has high volatility, can provide outstanding trading opportunities.
Unlike standard equity options, which expire on the third Friday of every month, VIX options expire on one Wednesday every month. There is no question that these options are being used, so they provide good liquidity. For all of March 2006—the first full month of trading for VIX options—total volume was 181,613 contracts, with an average daily volume of 7,896. Open interest already stood at a very healthy 158,994 contracts at the end of March. By February of 2012, the volume for options averaged above 200,000.
The Bottom Line
VIX options are powerful instruments that traders can add to their arsenals. They isolate volatility, trade in a range, have high volatility of their own, and cannot go to zero. For those who are new to options trading, the VIX options are even more exciting. Most experienced professionals who focus on volatility trading are both buying and selling options. However, new traders often find that their brokerage firms do not allow them to sell options. By buying VIX calls, puts, or spreads, new traders gain access to a wider variety of volatility trades.