Managing and profiting on volatility

September 30, 2009 07:00 PM

The Chicago Board Options Exchange currently has a number of indexes based on volatility. The granddaddy of them all is the CBOE Volatility Index, or VIX. The VIX is based on the implied volatility of the S&P 500 options. There is the CBOE Dow Jones Industrial Average Volatility Index, or VXD. Other indexes are the CBOE Nasdaq 100 Volatility Index (VXN), the CBOE Russell 2000 Volatility Index (RVX), the CBOE Crude Oil Volatility Index (OVX), the CBOE Gold Volatility Index (GVZ) and the CBOE EuroCurrency Volatility Index (EVZ). Each one of these indexes follows the VIX methodology. GVZ is based on the implied volatility of the options on the GLD ETF (exchange- traded fund).

When the VIX was originally introduced in 1994, it was based on the implied volatility of S&P 100 options, commonly referred to as OEX options. In 2003, the VIX was changed to a measure of the implied volatility of the S&P 500 (SPX) options. Implied volatility is a reverse engineering process whereby the price of options implies the volatility of the underlying instrument that the options derive their value from. The premium paid for an option is divided into two parts. There is the intrinsic value and the time value. When the closing bell goes off on expiration day, there is no time value left. Prior to that time, the time value is based on the number of days until expiration and the demand for the option. The greater the uncertainty or fear in the marketplace, the greater the demand for options. That is why the VIX has acquired the nickname “fear gauge.”

Is there a large differential between spot prices and forward prices? There certainly is a significant difference. Let’s look at some examples. On Jan.10, 2006, the VIX closed at 10.86. The February VIX futures closed at 13.04. When the spot VIX jumped to a closing price of 14.50, the February futures closed at 13.55. When the VIX overshoots the mark, the futures generally trade at lower levels. When analyzing a financial instrument’s price, every investor, either consciously or unconsciously, pays attention to mean reversion.

When analyzing volatility, particularly index volatility, traders should pay even more attention to mean reversion. Five hundred stocks will not sit still forever, nor can wild gyrations in the stock market last indefinitely. During the volatility slump of 2005 and 2006, there was talk that financial engineers had found a way to take volatility out of the market as a variable to be considered. It will be a long time before anybody makes a statement like that again.

While the spot VIX might give you more bang for the buck, the current VIX futures and options can provide plenty of firepower. Who should be trading them? One obvious candidate would be a long- only fund. The more highly leveraged a long-only fund is, the more out-of-the-money calls should be held in their portfolio. If you look at a chart for VIX and turn it upside down, it looks like a chart for the S&P 500.

The inverse relationship between VIX and the marketplace makes the VIX a perfect hedging vehicle. Out-of-the-money VIX calls tend to work better than out-of-the-money SPX puts. Why is that? The SPX volatility skew to the downside is more positively skewed than the VIX volatility skew to the upside. What does that mean?

Volatility skew refers to the varying implied volatilities per strike price. Positive skew means that the further away from the at-the-money option, the greater the implied volatility. Negative skew means that the further away from the at-the-money option, the lesser the implied volatility. This means that the price for protection is higher when using SPX puts as your insurance. Since VIX calls are cheaper, more of them can be acquired.

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About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.