An Explanation of VIX Options

I’ve been discussing the VIX as a proxy for market volatility, and as a hedge against a crash. Some people have complained that the ubnderlying options — especially the longer dated calls — do not move in parallel with the VIX.

Part of the problem is the tendency for the VIX to snapback to prior levels after a spike.  Trading these options successfully requires a trifecta of sorts: You must get the direction, level and timing pretty close to precisely correct to get the maximum return.  Its tricky.

Barron’s Kopin Tan goes into the details:

"[VIX Option] Volume has soared since these were introduced in February, with 1.02 million VIX calls and puts trading in May — up from 285,994 in April. Yet they leave many investors perplexed.

For a start, because VIX peeks only 30 days ahead, its current reading can differ substantially from its forward value. Case in point: Even as VIX climbed toward 19 early last week, futures prices pointed to a more subdued VIX, at about 16 come November — a sign the market expects the current volatility spike to moderate in time. This is logical, since projected volatility tends to jump sharply and then ebb gradually, and premiums soared recently in part because so many option sellers had scrambled to cover their short-volatility bets."

But its more than that; the way VIX options get exercised have an impact on their trading:

"VIX options can only be exercised upon expiration. So a big jump in the VIX may not move longer-term call prices — if the market expects that jump to be fleeting. In other words, VIX options may not mirror real-time readings, although any divergence will decrease as options approach expiration. As a portfolio hedge, "buying VIX calls only helps in a crash right before expiration," says Tom Sosnoff, CEO of the brokerage firm thinkorswim Group.

Instead, those who expect volatility to increase — or at least not to decline — might be better off selling VIX puts, Sosnoff says. Because VIX options trade at strike-price increments that are 2.5 points wide, investors have a limited choice of what they can sell; and the situation will not improve until more flexible, one-point wide strikes are introduced.

But the VIX has swung dramatically from one day to the next, and is at its most volatile in years. Premiums from selling VIX options are thus high — for a reason. Because volatility can never fall to zero, and VIX has rarely fallen below 10, a seller of VIX puts has downside risk that is capped to a certain extent."

For high risk tolerant traders, instead of buying calls when cheap, the alternative strategy is selling out of the money puts:

"Still, the average investor might want to wait for the wild VIX swings to stabilize before looking to sell out-of-the-money puts. The premiums earned provide only a partial hedge against a market crash, but a careful seller of VIX puts can earn steady income over time — especially if the stock market becomes more volatile."

This is not for rookies, and investors should make themselves aware of the attendent risks and exposure of this . . .


UPDATE:  June 12, 2006 9:43am

Steven Smith asks "Is the VIX a ‘Fraud’?"

"An article in Barron’s this weekend discusses how VIX options don’t work too well for hedging against a market decline. It goes as far as quoting a reader who claims "this product is a fraud," referring to the fact that despite a nearly 70% increase in the VIX over the past four weeks, the value of November $15 calls have gained only about 20% during that time.

In previous posts I’ve discussed the two main reasons for the seeming lack of leverage or correlation: First is the fact that the options are priced and settled against VIX futures, not the cash or spot VIX index; second, as an instrument that has a tendency to revert to the mean, the futures will tend to discount moves, especially anything to what is viewed as an extreme level. This creates a dampening effect on options price movement.

The conclusion is that it will take a large crash very near expiration to see the price of calls really kick higher. Instead, as I’ve suggested before, it is better to sell puts on the notion that volatility can’t go to zero and historically the 10% level has pretty much been a floor, meaning the risk of an implosion which would cause a spike in put prices is minimal."


Vexed by the VIX
Barron’s Monday, June 12, 2006

"Is the VIX a ‘Fraud’?"
Steven Smith
Real Money, 6/12/2006 8:35 AM EDT

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What's been said:

Discussions found on the web:
  1. toddZ commented on Jun 11

    These options really offer about zero protection from a crash with the European style expirations… Why did they do that?

    At least when you buy some regular puts for protection you don’t have to worry about getting the timing exactly dead-on.

  2. wcw commented on Jun 11

    VIX options are not designed as “protection from a crash.” Why not just buy index puts? They are designed for someone who wants to hedge out or speculate on changes in market-implied volatility.

    I don’t know the CBOE’s thinking on them, but my guess is that American-style options would have ended up being much too expensive. Even the European style traded now sport high volatilities.

    If there’s no volume in the instrument it does nobody any good. Looking at that vol chart, I think the CBOE made the right decision.

  3. Mark commented on Jun 11


    I don’t see comments enabled on that inflation adjusted SP 500 chart. Great work! By that chart it would seem we have quite a bit of excess still to work off from that parabolic run-up in the 90s. Yikes.

  4. whipsaw commented on Jun 11

    I understand using options to trade volatility and have had some modest success with straddles based on the idea that the underlying was at low historical volatility and would return to greater gyrations soon. But I do not understand the appeal of VIX options.

    For one thing, what happens if you hold VIX calls until expiry and exercise? What exactly is it that you are buying and what economic purpose does it serve? I understand the economic functionality of futures and conventional options, but as far as I can tell VIX is just a metric that may be useful as an indicator of market sentiment, but doesn’t appear to have any value in its own right.

    Aren’t VIX options just another thrill park ride if they don’t serve an economic purpose? Wouldn’t it make just as much or little sense to offer options on the RSI of the Dow?

    Maybe I am missing the point entirely, but it seems to me that if you want to play volatility at the market level, you put a straddle or a strangle on QQQQ. If you want crash protection, you just buy puts against whatever you are holding. And in any case, the notion that the “average investor” has any business writing puts against VIX or anything else strikes me as absurd. Buying options is one thing, writing naked options is quite another from a risk management perspective.

  5. wcw commented on Jun 11

    Maybe I have a vested interest, having of late made money on my vix-option positions, but I don’t see these as any more artificial than any other securitization. Are there other proxies for the position? Sure. Is there a direct equivalent? I don’t see one.

    While I try not to adopt the dismissive tone, if you really see these as superfluous, you can probably find an arbitrage. Go, then, and profit.

    FD: I’ve been out of this market since I exercised my May 12.5 Vix calls. Not a big win, but memorable.

  6. whipsaw commented on Jun 11

    Okay, so what did you wind up with when you exercised your calls? And what did you do then? Do you now have X units of VIX in your account, are they marginable, or what?

    I would just like to understand what I get if I win if I am going to go at risk. I can’t say that I’ve pursued the subject rigorously, but I have yet to find anyone who can explain what the underlying VIX prize is aside from providing a vehicle to place your bets and hope for the best. That sounds a little too Enron-ish for my tastes (i.e., we don’t understand how it works, but it works), but maybe you guys can straighten me out about this? Thanks.

  7. Clarity commented on Jun 11

    If you’re hedging, why not just long the futures along with your equity positions during low vol periods?

  8. Get Long Vega commented on Jun 12

    #1: Euro vs. Amer exercise is irrelevant IMO. There is no dividend to early-exercise, so who cares? You can sell VIX futures against your long calls to get flat if you don’t want to puke the calls out altogether.

    #2: VIX options are CASH settled.

    #3: If you want to price your VIX options off cash VIX, be my guest. But maybe looking at the futures is a better idea.

    #4: The VIX “prize” is correctly betting on where implied volatility goes. If you understand what the VIX measures, then you understand what the prize is.

    #5: Sure, you can trade a straddle as a proxy for vol. But if you are not an institution, you’ve got to be really right to make money because there’s a 99% probability that you are not trading your gamma. Rather, you’re just trading break-evens.

  9. ndk commented on Jun 12

    Re: #1, I think there’s at least a small advantage to early expiration reflected in the typically higher prices of American-style options. It’s rare to exercise anything early, but if something is really bouncing around, picking a high point in the week preceeding doesn’t cost you much in lost theta.

  10. jkw commented on Jun 12

    I don’t understand why anyone would be willing to sell a cash-settled American style option. With physical settlement, if someone exercises on a large-but-brief price movement, you have the underlying instrument so when the price goes back to normal you are where you expected to be. But with cash settlement, someone can exercise on a brief price surge and you just lose. This means that cash-settled American style options have to be priced to include the worst-case price spikes. In which case they aren’t worth buying. I don’t see how you can have a market for American-style VIX options. Under what circumstances would you be willing to short American-style calls on VIX?

  11. whipsaw commented on Jun 12

    per Vega

    “#4: The VIX “prize” is correctly betting on where implied volatility goes. If you understand what the VIX measures, then you understand what the prize is.

    #5: Sure, you can trade a straddle as a proxy for vol. But if you are not an institution, you’ve got to be really right to make money because there’s a 99% probability that you are not trading your gamma. Rather, you’re just trading break-evens.”

    If they are cash settled, then that explains a lot and to me, the cash is the prize. But I still don’t see the economic functionality of the “product” (meaning what purpose does it serve other than speculation?).

    My straddle efforts have been based on using Larry McMillan’s daily hit lists of issues with abnormally low volatility then running a few candidates thru his monte carlo gaming tool. One pretty good winner (ELX15) that I managed to close just before it crapped out recently, a few small losers, couple of break evens that were a waste of time. In any case I am out of that business for a while in favor of directional trading against the index ETFs.

  12. whipsaw commented on Jun 12

    bah, that should have referred to “ELN15”, ELX was a loser. Sorry.

  13. VIX Trader commented on Sep 13

    I trade the VIX for income by waiting in cash for spikes and then buying diagonal spreads using the near term two months and a series 2 months out from the selected near term month. When the VIX spiked this month, I purchased $25 dec calls and sold Oct $27.5 calls. I also did the same with the Nov $25’s and Sept $25’s. When the VIX spikes, you can get some sizeable premiums for the near term months resulting in decent credits. Essentially I earn income on these by betting against extreme crashes when the market has already made a significant quick move down. I favor this stragey because the margin requirements are so rediculously low.

    It’s generally a really bad idea to be buying calls or puts on the VIX and even worse if you buy the near term months. Thos never apreciate in price comensurate with large moves in the VIX. It’s much better to wait for the move and then sell the volatility of volatility.

  14. john commented on Nov 13

    Why can’t they have sth. that based on the spot price instead of the stupid European future price? This product is really a fraud!

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