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.
One other candidate would be a diversified portfolio that is net “short premium.” This portfolio would be a beneficiary of decay in the options. A “short premium” portfolio would be subject to an increase in implied volatility. That would mean even more premium that would decay. That is not a great situation if the investor sold premium at a lower level. If managed properly, the investor could still benefit from decay without becoming insolvent in the process should a Black Swan event take place. Another reason to trade VIX options is because it has become a robust market with plenty of liquidity.
Let’s say that an investor with $1 million invested in a long-only fund purchases 100 VIX November 40 calls for $1.70. There is then a 20% sell-off in the market. The VIX pops up to 60 and the November futures are trading at 54. The November 40 calls are trading at 15.70. While the long-only portfolio loses $200,000, the VIX calls return a profit of $140,000. It turns out to be a 6% loss instead of a 20% loss.
The VIX is a real-time market estimate of expected volatility that is calculated by using the bid/ask quotes on S&P 500 index (SPX) options. VIX uses the options from the two nearby expiration cycles with at least eight days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 index. Both at-the-money and out-of-the money puts and calls are involved in the calculation. Zero bid calls and puts are not involved in the calculation. This means that the number of options used in the calculation is in a constant state of flux. When the market is highly volatile, investors are willing to pay something for far out-of-the-money options that they normally would not.
VIX options (VRO) are European style options that can only be exercised on the expiration day. American style options can be exercised at any time. One day each month, on the Wednesday that is 30 days prior to the third Friday of the following calendar month, the SPX options expiring in 30 days account for all of the weight in the VIX calculation.
VIX options settle on these Wednesdays to facilitate the special opening procedures that establish opening prices for those SPX options used to calculate the exercise settlement value for VIX options. The Tuesday before it is the last full day of trading. The exercise settlement value for VIX options (VRO) is a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices of the SPX options used to calculate VIX at settlement. Opening prices typically reflect actual trades. If there is no trade, then the middle of the bid/ask is used.
Only series with non-zero bid prices upon completion of the special SPX opening procedures are used in the SOQ calculation.
INDEXES
VIX has been used by market participants for many years as a valuable fear gauge of the market, and the various additional VIX products can be a valuable tool as well even though they are not tradeable to date. This is particularly true of the volatility measures of currencies and commodities. Because VIX is based on equities — the underlying of which will always have a long bias — it tends to be negatively correlated with the market. It looks like a measure of weakness more so than volatility at times and can shrink in the face of unquestionably volatile upward moves. Because the underlying of commodity volatility products can be sold as easily as it is bought, it can be argued that it tracks actual volatility better (see “Variety of VIX,” page 41). The traditional VIX declined steadily from the November 2008 S&P low to the March 2009 S&P low despite several sharp upward corrections that were soon reversed.
Traders can use these measures to manage their positions and risk accordingly, the same way risk managers have used the VIX for decades. The VIX on commodities and currencies may even be more valuable, as it will be a better signal of the risk in an overheated bull market.
BINARIES
Binary options are the latest volatility tools on the horizon. The CBOE is set to roll them out at any time. BVZ is the ticker symbol that will be used. Binary options are a fixed all-or-nothing proposition. If, at expiration, the settlement price of the VIX closes at or above the selected strike price, the buyer of a BVZ call receives $100 per contract. If the VIX closes at a price that is below the strike price on the expiration date, the BVZ call buyer receives nothing. The BVZ put buyer receives $100 per contract if the VIX settlement price closes below the strike price at expiration, and nothing if the VIX closes at or above the strike price at expiration. It is irrelevant how deep-in-the money the options are. Today the only viable volatility tools are VIX futures and options.
Keep your eyes peeled for both the binary options and the sector specific, particularly oil and gold options
on volatility.
Dan Keegan is an options instructor and head options mentor at www.TheChicagoSchoolofTrading.com.
