Trade volatility is nothing new for options traders. After all, most of them rely heavily on volatility information to choose their trades. The Cboe Options Exchange Volatility Index, with its ticker symbol VIX, has been popular with traders since its introduction in 1993.
Options traders once used stock options or regular indices to trade volatility, but many quickly realized that it was not ideal. In February 2006, the Cboe launched 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 benefits that VIX options offer.
- The Cboe introduced VIX options in 2006 to give investors more direct access to volatility.
- The VIX measures the market’s expectation of S&P 500 30-day volatility implicit in the prices of short-term S&P options.
- A fixed trading range and high volatility also help make VIX options useful to speculators.
What is the VIX?
The VIX is an implicit volatility index. Measures the market’s expectation of 30-day S&P 500 volatility implicit in the prices of short-term S&P options. VIX options provide traders with a way to trade volatility without having to consider other factors that are generally involved in option prices. These complicating factors generally 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 to be very useful in trading, but it now provides excellent opportunities for both hedging and speculation. VIX can also be an excellent tool in your quest for portfolio diversification. Diversification, which most investors find highly desirable, is useful only if the selected stocks are uncorrelated. In other words, if you own ten great tech stocks that tend to move together, then you’re not really diversified.
An advantage of the VIX is that it has a negative correlation with the S&P 500. According to the Cboe, the VIX has moved against the S&P 500 Index (SPX) 69% of the time since 1990, with an even higher correlation during the most volatile years. . like 2008. On average, the 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 disaster insurance on the market.
Buying VIX calls could be an even better hedge against declines in the S&P 500 than buying SPX put options. The graph in Figure 1 shows how the VIX moves in the opposite direction of the SPX in its big downward moves. The VIX hit a closing high of 80.86 during the 2008 financial crisis. That record held for more than a decade. However, the VIX hit a new close record of 82.69 during the 2020 bear market.
As you can see in Figure 1, the VIX is trading within a certain range. It bottoms around 10. If it reached zero, it would mean that the expectation was that there would be no daily movement in the SPX. On the other hand, the VIX rose above 80 when the SPX crashed. However, the VIX can’t stay there either. A consistently high VIX would imply that the market’s expectation was for substantial changes over an extended period of time.
A fixed trading range means that VIX options offer excellent opportunities for speculation. Buying calls, buying bullish call spreads, or selling bullish 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, buy put, buy spreads Bearish Put or Sell Bearish Call Spreads can help a trader make a profit when the VIX peaks.
Another factor that improves the effectiveness of VIX options for speculators is their volatility. According to the Cboe, the volatility of the VIX itself was over 80% for 2005. That compares with about 10% for SPX, 14% for the Nasdaq 100 (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 VIX “spot”. Instead, it is based on forward value using current month and next month options. The volatility of the forward VIX is lower than that of the spot VIX (around 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 excellent trading opportunities.
Unlike standard stock options, which expire on the third Friday of each month, VIX options expire on a Wednesday of each month. There is no doubt that these options are being used, so they provide good liquidity. For all of March 2006, the first full month of trading VIX options, total volume was 181,613 contracts, with an average daily volume of 7,896. Open interest already stood at 158,994 very healthy contracts at the end of March. In February 2012, the volume of options averaged over 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 a high volatility of their own, and cannot go to zero. For those who are new to options trading, VIX options are even more exciting. The most seasoned professionals who focus on volatility trading are both call and put options. However, new traders often find that their brokerage firms do not allow them to sell options. By buying calls, put or spreads on VIX, new traders gain access to a wider variety of volatility trading.