Introducing the VIX of the VIX

optionsguy posted on 07/26/12 at 04:29 PM

TradeKing Senior Options Analyst, Brian Overby, gives some insight on a new volatility index and discusses an option strategy that may be useful when trading VIX option contracts.

Hello Traders,

There are many ways option contracts that trade on the VIX index are different than standard option contracts, which ultimately makes them tricky to trade. I have recently outlined many of the reasons in my blog. One of the blogs is titled, “Are there really VIX options?” and more recently “Where's the VIX future again?”. Today I would like to discuss the actual pricing components in the option contracts, more specifically the implied volatility (IV). So the question to start with is “what is the implied volatility of the option contracts in the implied volatility index?” - definitely a mouthful!

The Chicago Board Options Exchange (CBOE) recently made the answer to this question easy to find. They developed a “VIX of the VIX” index and called it “The CBOE® VVIXsm Index”. The symbol for this index according is VVIX. The description from the CBOE’s web site is the following:

“The VVIX is a volatility of volatility measure in that it represents the expected volatility of the 30-day forward price of the CBOE Volatility Index (the VIX®). It is this expected volatility that drives the price of VIX® nearby options. The VVIX or any point on its term structure is calculated from a portfolio of VIX® options using the same algorithm used to calculate the VIX®.”

Historical Behavior of VVIX and VIX June 2006 - February 2012 (source: CBOE.com)



The above chart shows us that although the VIX (in red) is a very volatile index, the VVIX is quite a bit more volatile. The VIX range in the 6 year period (obviously including the 2008 financial crisis) is around 13 on the low end and 80 on the high end, but the VVIX range is somewhere between 60 and 140 for the same period. Also, the chart shows the VVIX traveled that entire range many more times throughout the period.

What does all of this tell us? Not only do trading option contracts based on the VIX index have risk because of the wild price swings of the actual VIX index. The options overall have even more risk because of the wild swings in the implied volatility pricing component that is in all of the option premiums. If implied volatility is collapsing it will hurt a long option position and if skyrocketing it will hurt a short option position. So if buying or selling options outright, especially ones with a lot of extrinsic value in the price, your forecast on implied volatility is just as important as being correct on your forecast for the actual index. I would equate this to trading options in a high flying pharmaceutical stock that has the results of a phase 3 trial posted each and every trading day of the year.

What can we do about this fact? One thing about option trading is that when combining different option positions it is possible to mitigate certain risks. The simplest thing to do is to spread off your position. That means we buy one option and sell another option with a different strike and the same expiration date.  The concept is if implied volatility is hurting the one you bought it will be helping the one you sold and vice versa. For example let’s look at a call spread using actual VIX options. This is for educational purposes only and not meant to be a recommendation.

VIX/Q2 (Volatility Index Future 8/12) 21.05    -0.80



This would be a long call spread, the August Future is trading at 21.05 with 27 days left until the expiration of the contracts. (If you are wondering why I am quoting the future instead of the actual VIX index please read my blog titled “Are there really VIX options?”.) The commission to enter the trade would be $6.95. The max risk for the trade if we paid the asking price would be 1.30 and the max profit would be limited to the difference between strikes (24 - 20 = 4) minus the net debit paid (4 - 1.30 =  2.70) and as always don’t forget to include commissions in all of your calculations.

(**NOTE: option prices are given as a per contract amount. Multiply loss and gain figures by 100 shares and by the number of contracts traded to determine the amount of the full potential loss or full potential gain. No additional calculations are needed to determine commission costs.)

The reason we are spreading is to limit the amount of extrinsic value in the total position. To accomplish this we have to pay attention to the amount of extrinsic value you are paying on the purchased option and the amount you are receiving on the sold option. Implied volatility can only mess with the extrinsic value. It does nothing to the intrinsic value. So, by limiting the amount of extrinsic value that is in the position, we are mitigating the risk implied volatility swings can bring. In this case we are buying an in-the-money-option (the 20 strike) that has $1.05 of intrinsic value (21.05 - 20 = 1.05) and has 1.45 of extrinsic value (2.95 - 1.05 = 1.45). The option we are selling is an out-of-the-money option (the 24 strike) and has no intrinsic value, therefore, is made up of all extrinsic value $1.65.

So if we only focus on the the extrinsic value of the options, we see how much we have diminished the risk of fluctuations in the extrinsic value due to fluctuations in implied volatility and for that matter time decay.

Extrinsic Value of the spread:
24 Strike Call 1.65 Credit
21 Strike Call 1.45 Debit
Net Extrinsic  0.20 Credit

Now we only have a 20 cents of extrinsic value in the position and, as we mentioned earlier, implied volatility can only mess with this value.

The biggest thing to note when picking the options to trade in the spread is that we bought a in-the-money option and we sold a out-of-the-money option. In general on a directional based trade (this example was bullish), this has to be done if your goal is to make the extrinsic value of the position as close to zero as possible.

Regards,

Brian Overby

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

Follow Brian on Twitter or visit TradeKing on Facebook and YouTube.

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

At the time of publication and in the preceding month, TradeKing and/or Brian Overby did not have ownership greater than 1% in any stocks mentioned; did not have any other actual, material conflict of interest known at the time of publication; have not received compensation from a public offering nor from investment banking services related to any companies mentioned within the past 12 months, nor expect to receive any in the next 3 months; nor engaged in market making in the securities mentioned.

Futures data is supplied for educational purposes only. TradeKing does not currently support futures trading.

(c) 2012 TradeKing Group, Inc. Securities through TradeKing, LLC. All rights reserved.
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Posted by optionsguy on 07/26/12 at 04:29 PM

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