On the heels of last weeks post about the VIX, I had a few more thoughts that might be useful to share.

In the last post I described a very odd fact: many traders don't realize that the Volatility Index options (symbol VIX) are actually priced off of the VIX futures contract as the underlying.  This means that the relationship between the actual VIX index and the VIX options "based" on that index are little hard to follow. I wrote the post in response to a common experience I've been hearing about from customers.

Here is the situation:   Someone buys a VIX option today -- let's say a Feb07 VIX call option.  The VIX index then makes a sudden move, but the call option does not move as anticipated.  Why?

Usually, the unexpected price behavior of VIX option occurs because the VIX futures contract did not change as much as the VIX index.  As described in the previous post, the actual underlying for the option is the futures contract.

The next question, of course, is this: why didn't the futures contract change by the same amount as the VIX index?  Shouldn't the Feb07 VIX futures have a very close correlation to the VIX index as it is moving up or down? Strangely, the answer is, "No".  The lack of correlation between VIX futures contracts and the VIX index is especially true for the farther-out expirations. Why is this so?

An explanation is somewhat tortuous.  To start, consider a traditional futures contract, such as a futures contract on soybeans or oil. Unlike an option, a futures contract is the obligation for the buyer, not just a right, as it is for an option buyer. Think of how futures contracts were originally used.  Futures contracts were created to lock in a guaranteed price.  A farmer, for example, needs to make a lot of upfront investments to plant, fertilize, weed, water, and harvest a crop. If you were a farmer, wouldn't it make you feel more comfortable to know that, come harvest time, your selling price and your profit margin are assured?  Similarly, a buyer of corn would feel comfortable having locked in a purchase price.  This is how futures contracts were intended to be used. The price of a futures contract is based on what corn is trading for today, plus any carry costs over the period until delivery.  

VIX futures contracts, however, are different, there is no actual, physical VIX product or security (like soybeans or oil) that can be purchased and stored until some date in the future.

The VIX index is a weighted index (not a simple average) of the implied volatility of options on the S&P 500 Stock Index (SPX), which are traded at the CBOE.  A VIX index value at any given time is what the marketplace is implying about the volatility of the S&P 500 Stock Index in the short term -- specifically the coming 30 days.

Since there is no objective method of determining what the VIX index will be at any given date in the future, there is no "cost to carry" like there is for a traditional commodity.  The bottom line is that the price of a VIX futures contract is determined by many non-definable factors that make up supply and demand such as current market conditions, recent news and sentiment of traders.

In simple terms, trading VIX options is like trying to trade options on the temperature at some future date. If, for some odd reason, the temperature in south Florida reaches 120 degrees on October 5, that does not help someone to predict the temperature on February 5 of next year.  Perhaps, if there a string of 120-degree days, then, maybe, there could be a trend that might presage a warmer winter and a higher than normal temperature on February.  Under normal conditions, however, what happens to the temperature on one particular day in September bears very little relationship to what weather will be in February.

The same concept largely holds true for predicting the VIX index: an unforeseen event today that makes the market very volatile in the near-term does not mean that the market will continue to be that volatile in the future.

Consequently, when the VIX index has a large swing, it does not necessarily mean the February VIX futures contract will respond accordingly. Since professional traders use VIX futures contracts to hedge their VIX options positions, the main factor affecting VIX options prices is the movement in the corresponding VIX futures contract.

Futures contracts that have no physical underlying -- like VIX futures -- are more abstract than futures on hard commodities like corn. Comparing a Feb07 future with the actions of the VIX Index in September, or even with VIX Sept07 futures, is like comparing a MSFT option with an IBM option. The two underlying entities are fundamentally different, and they will respond differently to changes in the market place.

My best advice to those interested in VIX options is this: try to stick to shorter-term contracts. Those contracts will bear more relationship to the current moves of the VIX index, and you can strategize accordingly. By the same token, know that VIX options are a truly wild, speculative ride.  Plan your risk and exit strategies accordingly.

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility there is no guarantee that this forcast will be correct.