Where's the VIX future again?

optionsguy posted on 06/29/12 at 09:01 PM

TradeKing Senior Options Analyst Brian Overby discusses the VIX option contracts and how to use a VIX index option chain to help determine the value of a VIX future contract.

Recently I wrote a blog titled “Are there really VIX options?” and in the blog I discussed in great detail that VIX options are not priced off of the VIX index, they are actually priced off of the movement of the VIX future contract. Therefore, the main factor affecting VIX options prices is the movement in the corresponding VIX future contract with the same expiration as the option contracts. A graph of the VIX index versus a further out in time future was used to show that many times the future contract does not move in tandem with the actual VIX index. Obviously, this fact makes trading VIX option contracts quite tricky. They are definitely not your father’s option contracts.

Knowing where the VIX future market for the specific option expiration is critical before attempting any option strategies in this index. Therein lies the issue that I would like to address in this blog today. Many individual investors who would like to trade options in this underlying do not have access to real time futures quotes because most don’t have a futures account. Don’t fret if this is case, there is a pricing trick using the price of put and call options on the same strike line and same expiration that can determine where the underlying market is for the contracts. (TradeKing does not currently support futures trading. Any discussions on futures pricing data is supplied for educational purposes only.)

To understand this concept it is important to grasp that the price of the underlying stock or index, the call value and put value are all tied together. They have to be or arbitrage situations would be created and institutional investors would take advantage of those opportunities for as long as they were available. With options it is possible to create a long stock position synthetically, that is the key point to figuring out the price of the underlying, which is the VIX future contract.

Synthetic defined: A financial instrument that is created artificially by simulating another instrument with the combined features of a collection of other assets.The synthetic stock would have the same capital-gain potential and overall cost as the underlying security.

Using the VIX future quote from the CBOE and from the TK option chain after the close of market yesterday, we will build a synthetic future with put and call options. Then compare it to the CBOE actual future market quote.



First let’s pick the strike that we will use to build the synthetic long stock position. We see the actual VIX index is at 19.71 and we have an August expiration with 55 days of life left. On the chain we have the calls on the left and the puts on the right. To start with we want to use the strike that is close to the value of the actual future contract for the August expiration. So to determine that, we want to see where the call value and put value “switch” per se. This is easier to explain with an example. Concentrate on the 23 strike line to start. We see the call is asking 3.40 and put is asking 3.10. Obviously, the call is more expensive than the put. Now if we focus on the 24 strike line we see the put is asking 3.80 and the call is asking 3.00. Obviously, the put is more expensive than the call on that strike line. This means the 23 strike call is currently in-the-money and the 24 strike put is currently in-the-money. Therefore, the VIX future for the August expiration must be pricing somewhere between 23 - 24. Quite a bit higher than the actual index (VIX @ 19.71).

Now we will build a synthetic stock position based on the 23 strike line (note: we can use the 24 strike line if we wanted, it doesn’t matter.) If we zoom in on the 23 strike line we see the bid and ask for the call on the left and the put on the right.



To form a synthetic stock we have to buy the call and sell the put. We want to use the midpoint of the bid/ask for pricing. Remember we are just pricing the underlying we are not placing this trade.

Buy a call at 3.30
Sell a put at 3.00             Commission $6.25
Net debit of 0.30

The call is the right to buy the underlying at 23 and the put is the obligation to buy the underlying at 23. If we did put on this position and the underlying was above 23 at expiration we would exercise our call, buy the underlying at 23 and the put would expire worthless. If the stock was below 23 at expiration the underlying would be assigned to us at 23 via the obligation created by the sale of the put and the call would expire worthless. So we have the same risk as owning 100 shares of the underlying outright no matter what happens - unlimited upside and substantial downside if the underlying went to zero . So synthetically the same - well almost. Remember we had to pay a net debit to do this trade - 30 cents. So that is an additional cost that must be included. Adding in this cost to the buy price of 23 lets us know about where the underlying has to be trading 23 + 0.30 = 23.30. So the VIX future contract has to be trading for around 23.30.

To double check our math, I used a delayed futures quote provided by CBOE.com, but since the market was closed it was basically real time.



The quote for the August future (symbol VIX/Q2) was 23.27. We came up with 23.30 just a few cents off and that is understandable when you are dealing with bid/ask spreads and rounding issues.

This strategy is also known as combination or combo for short. You can read more about this topic inside the TradeKing education center, just look up long combination in the option strategy section.

Regards,

Brian Overby

TradeKing Options Guy and Senior Option Analyst www.tradeking.com

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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

Online trading has inherent risks dues to system response and access times that may vary due to market conditions, system performance, and other factors. An investor should understand these and additional risks before trading.

Any examples used in are for illustrative purposes only — they should never be construed as recommendations or endorsements of any kind. No particular trading strategy, technique, method or approach discussed will guarantee profits, increased profits or provide minimization of losses. Past performance, whether actual or indicated by simulated historical tests, is no guarantee of future performance or success.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies

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Posted by optionsguy on 06/29/12 at 09:01 PM

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