From the July 01, 2007 issue of Futures Magazine • Subscribe!

VIX, it protects and diversifies

The Volatility Index, or commonly known as VIX, was designed to track the level of implied volatility of S&P 500 Stock Index (SPX) options, which are cash-settled index options based on the S&P 500 Stock Index.

BACKGROUND

Implied volatility is the volatility percentage that justifies the market price of an option. Option contracts are like insurance policies, and the volatility component in option prices corresponds to the risk factor in insurance premiums. Risk premiums in insurance can differ from historic risk because the market can expect that future risk will differ from history.

Similarly, implied volatility in option prices can differ from the historic volatility of the underlying stock because the market can expect that future stock price action will differ from the past.

For options on market indexes implied volatility can vary by strike price and expiration. It is sometimes difficult, therefore, to say whether implied volatility is rising or falling. The VIX was created to address this problem. Just as the S&P 500 is a measure of changing stock prices, the VIX is a measure of changing levels of implied volatility. Specifically, VIX is a measure of market expectations of near-term volatility conveyed by SPX option prices.

VIX AND THE MARKET

“Opposites attract,” (below) illustrates the well-known inverse relationship between the S&P 500 and VIX. The chart shows several instances in 1998 when a rising S&P 500 was accompanied by a level-to-declining VIX and when a falling S&P 500 was accompanied by a rising VIX. It also shows that January through July 1998 was characterized by a gradually rising or sideways moving market (the upper line) and a steady-to-declining VIX (the lower line).

However, conditions changed during the August to September period. The S&P 500 declined 19% to 956 from 1,184, and the VIX Index rose to 44.28 from 16.23. After a brief rally, the market again tested its low on Oct. 8, and the VIX tested its high. For the rest of 1998, the market as measured by the S&P 500, experienced a steady rise and the VIX experienced a steady decline.

“Holding up,” (below) shows the S&P 500 and VIX from May 2006 through April 2007. Again, the general relationship is that a sideways or rising market is accompanied by a sideways or declining VIX, and a declining market is accompanied by a rising VIX.

The traditional explanation for the inverse relationship between the S&P 500 and the VIX is that “investors panic” when the market declines. Specifically, when the market shows signs of weakness, investors and traders rush to buy index puts, which creates an imbalance of demand versus supply. The result is an increase in implied volatility, which is a rise in option prices relative to the market level.

In contrast, when the market is sideways, there is a better balance between demand for, and supply of options. As a result, implied volatility remains constant. The tendency of VIX to fall as the market rises is believed to occur because option sellers become more aggressive as bullish market sentiment becomes more prevalent.

INTRODUCTION OF VIX FUTURES

The potential value of trading the VIX can be understood through this inverse relationship. Imagine a hypothetical $100,000 portfolio that had 90% invested in the S&P 500 and 10% invested in the VIX. When the S&P 500 declined from 1,184 to 956 between July 7 and Sept. 28, 1998, that would be a 19% decline in portfolio value, or a $17,000 loss for the S&P portion of the portfolio.

However, during that same period, the VIX index rose from 16.23 to 44.28, more than a 250% increase. Had it been possible to invest $10,000 in the VIX index, that portion of the portfolio would have increased $25,000, which would have more than offset the decline in the S&P portion of the portfolio.

Based on this knowledge and in response to investor and trader demand, the cash-settled futures contracts on VIX were launched at the Chicago Board Options Exchange. Futures on VIX provide a pure play on implied volatility independent of the direction and level of stock prices. VIX futures also may provide an effective way to hedge equity returns, to diversify portfolios, and to spread implied volatility against realized volatility.

A HEDGE FOR SHORT OPTIONS

There’s a reason why the number of commodity trading advisors (CTAs) who sell options, both covered and uncovered, has grown dramatically in recent years. The rap against short option strategies is that, yes, they work most of the time, but occasionally a spike in volatility wipes out all of the profits and sometimes more than that. But there are now strategies using VIX options and futures that can hedge such risks.

The term “an increase in volatility” can mean two things. First, it can mean a sharp price change, up or down, in the underlying stock or index. Second, it can mean a rise in implied volatility, which is part of an options’ price.

Sharp declines in the market are frequently accompanied by sharp rises in the VIX index. Therefore, the strategy of maintaining a long VIX futures position and the strategy of owning out-of-the-money VIX calls are both viable strategies for hedging against a market decline. Both of these strategies, however, have a cost and will eat into the profits generated from selling options. But when this insurance pays off it could be equal to or greater than the loss incurred from a declining market.

VIX futures and options are particularly useful in hedging delta-neutral, or nearly delta-neutral, positions against a rise in implied volatility. One very popular short option strategy is the iron condor, which consists of two parts: a credit call spread and a credit put spread.

Typically, both spreads are out-of-the-money when established.

Iron condors remain nearly delta-neutral unless one of the spreads moves in-the-money as expiration approaches. The initial risk when establishing an iron condor is an increase in implied volatility, and this is where VIX futures or options come into play.

Assume the SPX is 1,500 and there are 45 days to expiration. With implied volatility at 10%, an iron condor 50 points out-of-the-money might be established for 6.20 net by selling the 1550-1575 Call Spread for 3.80 and selling the 1450-1425 Put Spread for 2.40. If implied volatility (VIX) were to rise from 10% to 15%, this iron condor could rise in price to 10.00, which is a loss of 3.80, or $380, per spread. If a trader were short 100 of these spreads, then the loss would be $38,000.

At the same time that the VIX Index was rising from 10.00 to 15.00, it would be reasonable to expect that the near-term VIX futures would rise from 11.50 to 14.00, which is a $2,500 price rise per contract. It would also be reasonable to expect that the near-term 12.50-strike calls would rise from 0.60 to 1.80 for a $1,200 gain per option.

Therefore, assuming these price changes, it would require approximately 15 long VIX futures contracts or 24 long 12.50 calls to hedge the loss of $38,000. The risk of the futures hedges, of course, is a decline in price, and the risk of the options hedge is the full cost of the options plus commissions.

UNIQUE PROCING OF VIX FUTURES

Prices of VIX futures contracts are determined in a different way than prices of traditional futures contracts such as corn futures or futures on the S&P 500. Prices of traditional futures contracts are based on a “cost of carry” calculation. If corn is trading at $3 per bushel, for example, and if interest, storage, insurance and other carrying costs amount to 10% per year, then the fair value of a one-year corn futures contract is $3.30. If the market price of futures contracts rises above $3.30, say to $3.35, then arbitrageurs will sell futures and buy corn in the cash market. The corn will be stored for one year and delivered against the futures contract, and the result will be a nearly riskless profit of 5¢ per bushel.

VIX futures contracts are different than traditional futures contracts because there is no underlying cash commodity. Consequently, there is no arbitrage-pricing relationship, and no role for arbitrageurs to play. This means that the VIX Index can rise or fall dramatically today, but the price of a VIX futures will not necessarily move in tandem with the VIX index — as corn futures do with cash corn prices.

Prices of VIX futures contracts are based solely on expectations. Specifically, the price of a VIX futures contract represents the market’s expectation of what 30-day implied volatility of SPX options will be on expiration day.

“A different index,” (below) shows the closing levels of the VIX Index and the closing prices of the February 2007 VIX futures contract from March 8, 2006, through expiration on Feb. 14, 2007. Prices of the February 2007 VIX futures seem to be little affected by the VIX Index from March through October 2006. The futures price did rise in June 2006 from approximately 15.00 to approximately 17.00 when the VIX Index rose from approximately 12.00 to 23.00, but there was generally little correlation between the two lines until November 2006, which was about three months before expiration.

The simple message is that VIX futures are increasingly responsive to the VIX as expiration approaches. It follows, therefore, that the near-term VIX futures contract should be traded if the forecast calls for an imminent rise or fall in the VIX.

UNIQUE CHARACTERISTICS

VIX options have one major difference from most other options, and that is the underlying instrument. When pricing IBM options, the underlying price is clearly the price of IBM stock. Similarly, for options on July corn futures, the underlying price is the price of the July futures contract. For VIX options, however, the price of VIX futures should be used as the price of the underlying and not the VIX Index.

This leads to some seemingly unusual price relationships. On Oct. 16, 2006, for example, the VIX Index closed at 11.09, the February 2007 VIX futures closed at 15.19, and the February ’07 VIX 15-put closed at 2.40. To the casual observer, with the VIX at 11.09, it might seem that a 15-put has intrinsic value of 3.91. It would, therefore, seem that the Feb. 15 put was trading 1.51 below parity.

However, when you see that the Feb. 15 Call closed at 2.60, it is clear that the February futures price of 15.19, the 15 call price of 2.60 and the 15 put price of 2.40 are almost perfectly in line with put-call parity. Remember, also, that VIX options are European-style, so early exercise is not possible. The conclusion is that VIX options are not necessarily “cheap” if they appear to be trading for less than intrinsic value compared to the VIX Index.

VIX futures and options also have unique expiration dates. They both settle on a Wednesday that is 30 days before an SPX options expiration. Because there are four weeks between many SPX option expirations and five weeks between some, expiration of VIX futures and options can occur on the Wednesday before some SPX expirations (when there are four weeks to the next expiration) or on the Wednesday after (when there are five weeks between expirations). The last day of trading for VIX futures and options is a Tuesday, and then they settle on Wednesday morning to a special opening quotation of the VIX Index.

POSSIBLE STARTEGIES

The unique pricing characteristics of VIX futures and options leads to some unique thinking when it comes to picking a strategy that targets the goal of protecting a portfolio.

With regard to VIX futures, the conclusion from “A different index,” is that the front month VIX futures contract is the most responsive to changes in the VIX Index.

Therefore, if you expect a market decline in early August, then the August VIX futures contract is the contract of choice. If your forecast calls for a decline in late August or early September, then the September contract is the contract to pick.

However, if your forecast calls for a decline sometime in the next six months, you are stuck because you are unsure when the decline will occur. The choice of a VIX futures contract for hedging purposes is more difficult than is the selection of a traditional futures contract.

The same problem of capturing movement in the VIX confronts buyers of VIX call options. Front-month VIX calls are likely the most responsive to changes in the VIX, and fear of a market decline in the futures makes it difficult to select the right expiration for purchased calls.

The purchase of puts to protect individual stocks and portfolios is a well-known strategy. When it comes to VIX puts, however, the thinking is reversed. Because the VIX usually rises when the market declines,

VIX puts can also be expected to decline. Therefore, selling VIX puts is arguably a portfolio-protection strategy. However, the risk of selling puts should not be overlooked.

“A different index” shows VIX futures tend to trade at a premium to the VIX index until three or four weeks prior to expiration when the futures begin to converge to the index.

If the VIX remains unchanged, and if VIX futures are at a premium prior to Expiration, then the futures will decline to the index level at expiration. The choice of which VIX put to sell and balancing the potential profit with the potential risk makes selling VIX puts another strategy with difficult decisions that traders must make.

James Bittman is senior instructor at the Chicago Board Options Exchange’s

Options Institute.

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