Trading volatility is nothing new for options traders. After all, most of them rely heavily on volatility information to choose their trades. Volatility represents the extent of changes in the price of a stock, security, commodity, or index over a defined time period. Volatility also helps provide a metric for the magnitude of a price move.
The 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.
In February 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.
- The Cboe introduced VIX options in 2006 to provide investors with more direct access to volatility.
- The VIX measures the market's expectation of 30-day S&P 500 volatility implicit in the prices of near-term S&P options.
- A fixed trading range and high volatility also help make VIX options useful to speculators.
- Typically, the VIX is negatively correlated with the S&P 500, allowing investors to hedge against market downturns.
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 diversified.
Negative Correlation between VIX and S&P
One advantage of the VIX is that it has a negative correlation with the S&P 500. According to the Cboe, the VIX has had a negative correlation of -.69 with the S&P 500 Index (SPX) since 1990. In other words, the VIX has moved opposite of the S&P 500 Index 69% of the time since 1990. The negative correlation between the VIX and SPX was greater during challenging years in 2008 (-.83) and 2018 (-.88).
From 1990 to Sept. 2019, the SPX dropped more than 6.5% on eight dates, and on those dates, the average up-move in the VIX Index was 25%. The negative relationship between the VIX and SPX can make it an excellent diversification tool, providing market disaster insurance.
VIX Call and Put Options
Buying VIX call options (gives the holder right to buy the VIX) might be an even better hedge against drops in the S&P 500 than buying SPX put options (gives the holder the right to sell the SPX).
The chart below shows how the VIX moves in the opposite direction of the SPX during its significant 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.
The above chart shows how the VIX trades within a given range, bottoming out around ten. 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 the VIX tops out.
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. VIX options can offer a higher volatility rate than some stock options available to investors. An instrument that trades within a range cannot go to zero, and its high volatility can provide outstanding trading opportunities.
However, volatility is a double-edged sword, meaning just as the VIX can rise quickly, leading to financial gains, it can also drop quickly, leading to financial losses for investors.
Unlike standard equity options, which expire on the third Friday of every month, VIX options expire on one Wednesday every month. VIX options are traded frequently, providing investors with good liquidity, meaning investors can usually buy and sell without disruptions or delays when a broker fills a trade.
For example, in the first week of October 2021, VIX options had an average daily trading volume (ADV) of 420,000 for the week, which was higher than the previous week's ADV of 320,000. Although there's ample liquidity with VIX options, it doesn't guarantee that there won't be market disruptions.
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.