Trading volatility

October 27, 2016 09:00 AM
Volatility analysis offers a new perspective on the markets, but speculating in related contracts isn’t for everybody.

One market that has quickly become a popular topic in the trading and analyst community is the CBOE’s (Chicago Board Options Exchange) Volatility Index (VIX). It is a unique product, also known as the “fear gauge” for measuring implied volatility. 

CBOE describes the VIX as a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX value is derived from the implied volatility (the portion of an option price attributed to expectations of future volatility) in S&P 500 options. The VIX was introduced by CBOE in the early 1990s and is often considered to be the benchmark barometer of investor sentiment and market volatility (see “Listed options: A brief history,” Modern Trader, September 2016). Because the VIX is so widely watched and mentioned, it is only natural for futures traders to get involved. What started out as an index measuring market sentiment eventually became a popular futures and equity option trading instrument. 

In essence, VIX futures give speculators an opportunity to trade human emotions, specifically fear and complacency. 

There are some aspects of the VIX futures market that traders should be aware of before risking their trading capital. There are attributes of VIX futures that largely work against speculators, but there are times in which the VIX offers relatively predicable opportunities for those with strong stomachs. Let’s take a closer look. 

Playing the VIX is speculative, even more so than any other commodity because the underlying is not an asset, it is an opinion. In contrast, commodity futures contracts are similarly leveraged, and without income-producing elements, but their redeeming quality is being backed by tangible goods. Nonetheless, despite the lack of a concrete asset, there are times in which the odds of success in trading the VIX are eye catching, making it an attractive product. 

Equity Inverse

Although the word “volatility” generally refers to extreme price movement in any direction, in reference to the VIX and its value, volatility is highly directional. The VIX goes up when stocks drop, but it goes down when stocks rise. This is the case even if the stock market is soaring higher at an unusually quick pace. For this reason, traders and investors should look at bullish speculations in the VIX as being a bearish stance in the equity market, and vice versa (see “Mirror image,” below). They should not assume that a highly volatile bullish breakout in the S&P will increase the value of the VIX. 

Time Decay

New traders to VIX futures have been known to opt for going long the VIX as a substitute for purchasing a put option on the E-mini S&P 500. On paper, it appears to be sound logic; unlike a long put option, which exposes traders to the obstacle of time value decay, a futures contract shouldn’t see time value erosion. Yet, in the case of the VIX, it does — and it can cause substantial losses to a trading account.

Like long options, the VIX often wears away in value every day that lacks conviction selling in the S&P 500. If you’ve ever bought an option, only to watch the value of it dwindle to nothing while you were waiting for the market to move, you’ve experienced this. In other words, a trader looking for the equity markets to sell off in the near future might consider buying the VIX as a hedge against their stock portfolio or as a speculative play. However, if we see a week or two of sideways action, the VIX will likely have lost value because traders then adjust their expectations of future volatility to lower levels. 

In such an instance, the trader wasn’t necessarily wrong about the direction of the S&P; they simply weren’t immediately right. In the VIX, that is enough to lose money. VIX bulls typically have less capacity for miscue than bulls in other markets might due to the erosion factor (shown in “Sideways suffering,” below).

Contango Matters

“Contango” is a term used frequently but understood rarely. It describes the relationship between the cash market of a commodity and that commodity’s futures market. It is also commonly used to identify a scenario in which the value of futures contracts expiring in the near future are discounted relative to contracts with distant expiration dates.

Contango means people are willing to pay more for a commodity at some point in the remote future than the actual expected price of the commodity in the proximate future. In agricultural products such as corn, the price discrepancy is related to the cost-to-carry, such as storage and insurance. However, in the VIX futures, the contango is due to the uncertainty of human emotions and expectations. As time goes on, uncertainty dissipates. 

In most cases, the CBOE’s published VIX value (cash market) for purposes of market analysis is listed at a discount to the front month futures price, which is a tradable asset. Similarly, the next expiring futures month is typically higher than the front month (see “Price over time,” below). Because the VIX trades at a contango, if all else remains equal a trader long the VIX will lose money as time goes on because the futures price and the cash market price will converge. 

Quick and Slow

One of the redeeming qualities of the VIX is its capacity to rally sharply but decline slowly. Even more so, there has been a relatively solid floor in the VIX in the low teens (see “Market floor,” below). Because of this trait, it can make an attractive speculative play for bottom fishers. If the VIX is hovering near all-time lows, it appears to be a scenario in which the downside risk, albeit significant, is far less than the upside potential. In addition, if you happen to be skilled, or lucky, enough to get in just before a large spike in volatility, it is possible to realize an exceptionally large profit in a short period. Of course, this alone doesn’t negate the risks discussed previously. 

It is imperative traders are fully aware of the risk and reward prospects that come with being engaged in VIX before trading the futures contract. Unfortunately, inexperienced traders often casually go long or short the VIX without fully understanding the intensity of their position. Before the realization of risk comes to the forefront, the trade might already be thousands of dollars underwater on a single contract.

Understanding Pricing

On weekdays, trading in the VIX begins at 3:30 p.m. Central time and closes at 3:15 p.m. on the following day. There is a 15-minute pause from 3:15 p.m. to 3:30 p.m. to match that of the CME Group’s E-mini S&P 500 futures contract. 

Each tick in the VIX is worth $10; if the VIX moves from 13.00 to 13.01, that is $10. The minimum tick, or price movement, for this contract is 0.01, but you will rarely see the VIX move in one-tick increments. The spread between the bid and ask in this market tends to be five ticks ($50), much wider than most futures contracts. Oddly, the wide 

bid/ask spread isn’t due to a lack of liquidity; VIX futures trade tens of thousands of contracts per day. 

If the VIX moves from 13.00 to 14.00, traders long the market have picked up $1,000 ($10 x 100) in paper gains, but those short would have an equivalent unrealized loss. A tip for calculating risk and reward in commodities is to always work with a positive figure. Therefore, you will always be subtracting the higher price from the lower price and then multiplying by the tick value (in this case that is $10). The result will then be an absolute figure that must then be categorized as a profit or loss. 


The two most common hiccups new VIX traders experience are the massive bid/ask spreads and accepted order types. For instance, due to liquidity concerns, the CBOE doesn’t accept market orders during its designated extended trading hours (3:30 p.m. through 8:30 a.m. Central the following day). 

    In short, VIX traders cannot buy or sell the contract at the market price in the overnight trading session. Instead, they must place limit orders. This alone isn’t a big deal, but try telling that to a trader attempting to liquidate a trade gone bad, who is receiving rejection notices every time he enters an order to sell his long VIX contract at the market. 

Similarly, the CBOE doesn’t accept traditional stop-loss orders. Attempts at placing stop-loss orders are met with rejection notices upon entry of the order. VIX traders can, however, enter a stop-limit order, which is a type of stop order that limits the amount of slippage the trader is willing to take.

To refresh your memory, a stop order is one that is placed by a trader to buy a futures contract at a price that is higher than the current, or sell a contract at a price that is lower than the current, should the market reach the stated level. Once the stated stop price becomes part of the bid/ask, the order becomes a market order for immediate execution. 

A stop limit, on the other hand, becomes a market order if the stated stop price is reached but only if it is possible to fill the order within the stated limit price. If it isn’t possible, the order dies. This can be a nightmare for traders on the wrong side of a big move because their stop order goes unfilled, leaving them open to unlimited risk.

Bottom Line

As discussed, the VIX generally trickled down but has the ability to go up quickly. With this in mind, a VIX hovering at, or near, long-term lows can be an attractive place for aggressive traders to speculate. Although the risk is rather large, some view it as being relatively limited while offering seemingly unlimited profit potential. 

Editor’s note: This is an excerpt from Chapter 13 of “Higher Probability Commodity Trading” written by Carley Garner and published by DeCarley Trading, an imprint of Wyatt-MacKenzie Publishing.

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