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The Volatility Index (VIX) on the Chicago Board of Options Exchange (CBOE) is commonly known as the ‘fear gauge’ for the US stock market. It is a measure that tells options traders whether the volatility in the general market is low, neutral or high. The VIX is calculated using the two front month options of the S&P500 Index (SPX on CBOE) which are then weighted and averaged. The S&P500 is made up of the 500 largest companies that trade in the US stock exchanges.
In February this year the CBOE released options on the VIX. This allows options traders to trade the VIX through the buying and selling of calls/puts. There is one very important distinction that traders need to be aware of when trading this particular derivative. The VIX does not use the standard Binomial or Black Scholes option pricing models. The model used was specifically developed for the VIX. Why is this so? The VIX does not follow a log normal distribution. Basically what this means is that the VIX does not behave as a stock or index chart. This is why option charting software cannot create risk graphs for VIX trades.
Due to a different pricing model being used, the conventional intermediate to advanced options strategies involving vertical or horizontal spreads are not as effective. The best way to get to know what does or doesn’t work without risking money is to paper trade. All option brokers provide an options chain for the VIX.
Now that we know what the VIX options are, how can these be used to trade? Figure 1 below is a two year chart of the VIX that shows support and resistance levels along with a 50 day Simple Moving Average. Each time the VIX hits the resistance line a bearish strategy is ripe for analysis and likewise when support is reached a bullish strategy can be considered.
Chart 1 – VIX Daily Bar Chart
click chart for more detail
The expiration date is another important difference traders need to be clear about. VIX options expire on the Wednesday that is thirty days prior to the third Friday of the following calendar month. The options are European Style and cash settled. For example, upon expiration if the VIX was trading at 11.00 a 12.50 put would be worth $150 (1.50 x 100).
The release of options on the VIX has allowed traders a way to trade the general markets volatility. These options are quite different from conventional stock and index options. As with all aspects of trading it is important that traders totally understand the specification and behaviour of the security and how changes in the variables will impact the options value.
Make it happen!
Guy Halpin
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