What Is a VIX Option?

A VIX option is a non-equity index option that uses the CBOE Volatility Index as its underlying asset. Call and put VIX options are both available. The call options hedge portfolios against a sudden market decline, and put options hedge against a rapid reversal of short positions on the S&P 500 index. These options thus allow traders and investors to speculate on future moves in volatility.

Key Takeaways

  • VIX Options trade with the S&P 500 Volatility index as their underlying.
  • VIX call options make a natural hedge against downward price shocks.
  • VIX put options can be problematic because the S&P 500 index does not often rise rapidly.
  • VIX options trade as European style options.

Understanding VIX Options

The VIX option, which originated in 2006, was the first exchange-traded option which gave individual investors the ability to trade on market volatility. The trading of VIX options can be a useful tool for investors. By purchasing a VIX call option a trader can profit from a rapid increase in volatility. Sharp increases in volatility coincide with a short-term price shock in stocks. Volatility increase often, but not always, coincide with a downward trending market. As such, this kind of call option is a natural hedge and can be used very strategically over longer periods, and tactically in the short term. It many cases it can be a more efficient hedge than equity index options.

The VIX is susceptible to a pattern of slow decline and rapid increase. As such VIX call options, when well timed can be a very effective hedge; however, VIX put options are more difficult to use effectively. The put options can be profitable for traders who correctly anticipate that a market is about to turn around from a downward trend to and upward trend.

VIX options settle in cash and trade in the European style. European style limits the exercise of the option until its expiration. The trader may always sell an existing long position or purchase an equivalent option to close a short position before expiration. 

For advanced options traders, it is possible to incorporate many different advanced strategies, such as bull call spreads, butterfly spreads, and many more, by using VIX options. However, calendar spreads can be problematic since different expiration series do not track each other as closely as their equity options counterparts.

The Volatility Index Explained

The Volatility Index of the Chicago Board Options Exchange (CBOE) trades with the symbol VIX. However, the VIX is not like other traded instruments. Rather than representing the price of a commodity, interest rate, or exchange rate, the VIX shows the market's expectation of 30-day volatility in the stock market. It is a calculated index based on the price of options on the S&P 500. The estimation of volatility for these S&P options, between the current date and the option's expiration date, forms the VIX. The CBOE combines the price of multiple options and derives an aggregate value of volatility, which the index tracks.

Introduced in 1993, the Volatility Index (VIX) was initially a weighted measure of the implied volatility (IV) of eight S&P 100 at-the-money put and call options. Ten years later, in 2004, it expanded to use options based on a broader index, the S&P 500. This expansion allows for a more accurate view of investors' expectations on future market volatility. VIX values higher than 30 are usually associated with a significant amount of volatility as a result of investor fear or uncertainty. Values below 15 ordinarily correspond to less stressful, or even complacent, times in the markets.

Because of its tendency to move significantly higher during periods of market fear and uncertainty, another name for the VIX is the "fear index."