Are there really VIX options?

optionsguy posted on 03/28/12 at 01:19 PM

TradeKing Senior Options Analyst Brian Overby discusses the tricky VIX option contracts and some of the pitfalls that traders are running into when trying to track it.   

Hello Traders,

The CBOE Volatility Index (symbol VIX) is trading at the low end of it's yearly range. This has brought many speculators to the VIX option contact and to many other products that try to track the VIX index's wild swings. When the VIX option contracts were in their infancy I wrote a blog called, "Decoding the VIX" that was quite popular in the TradeKing Trader Network. In this blog, I described in detail an odd fact: the VIX options are not priced off of the VIX index, they are actually priced off of the movement of the VIX future contract. This is because the market makers in the Chicago Board Options Exchange VIX pit cannot buy the actual VIX index to hedge positions. Because of this, they use the VIX future contracts to hedge. 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. There are many times the future contract does not move in tandem with the actual VIX index or know as the spot index in terms of the future contract. Below is a graph of the price movement of the a future relative to the spot index.



(Note: VIX option contracts are European Style expiration which means they can not be exercised early, they can only be exercied at expiration. You can open and close contracts in the marketplace at any time though.) 

The above graph highlights the differences between the two products. It covers most of the life of the Feb 2011 Future contact, from 6/21/2010 until the expiration of the future 2/16/2011. 

There are three points I would like to highlight about the graph: 

1) Throughout most of the life of the future contract the VIX future is valued at between 7 to 10 points higher than the actual VIX index. Using this as a standard means, lets focus on the August 5th date, where the VIX is close to 20 on the graph. If you look to buy a 20 strike call that would be considered at-the-money relative to the quoted VIX index, but relative to the future you are buying a really deep in-the-money contract. Obviously, in-the-money contracts are more expensive than at-the-money contracts and if you are unaware of the relationship of the future to the option it would be hard to determine why it was so expensive. 

2) In the June month on the left side of the graph you see a big spike up to around 35 in the VIX index while the future has a more muted move. Then when the VIX roars back down and touches the 25 level, the future just hangs around the 31 to 33 level and stays in the area for the next month. Once again, a much more muted move than the actual index. This is a period where VIX option traders might expect to see big moves in the values of both calls and puts with February expirations. However, the option price swings didn't happen because of the tamed move of the future relative to the VIX index. 

3) Lastly, on the right hand side of the graph you see the future start trading in tandem with the index. This behavior is expected because at expiration of the future the value of the VIX is used to determine the settlement for both the futures contract and VIX options. Which means the future will equal the VIX index value on the end date. This time period in the life cycle of a VIX option is the one time where the actual index plays a "big" roll in the pricing of the options. 

Obviously you must grasp the concept of the futures driving the VIX option contracts prices before you ever trade VIX options. You can learn more from my other blog and video on the VIX options. Also, you can find out more and receive delayed quotes on the VIX Futures on CBOE.com. 

Next week we will cover the implied volatility component of the VIX contracts and what pitfalls are involved with trading these options with such high implied volatilities. 

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

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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. 

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Posted by optionsguy on 03/28/12 at 01:19 PM

Comments

incubus posted March 28, 2012 (04:51PM)

Outstanding article.

optionsguy posted March 28, 2012 (11:59PM)


Thanks for reading and the awesome feedback. It is nice to know someone appreicates the work. The VIX is definitly a tricky product to trade..

Regards,
Brian (Og)

incubus posted March 29, 2012 (08:38PM)

You might have noticed myself and several others discussing a similar topic in the forum at length -  http://community.tradeking.com/forum/categories/general/topics/7211-xiv-declining-volatility-outlook/forum_posts 

To you, we're probably weekend warriors providing a chuckle, but what they hey, it's pretty interesting.

This blog is an outstanding addendum regarding futures at expiry, especially where one member brought it up this week, though I'm unsure if it effects the ETN's discussed. (XIV, VXX, VXZ)

We've been more strongly focused on the effects of term structure on VXX, XIV and VXZ over prolonged periods, the effects of contango in roll decay (inverse) for XIV relative to a long position in VXZ as a hedge.


clreyz1 posted April 24, 2012 (06:11AM)

Hey Brian thanks for a eye opening article. Is it correct to conclude that the VIX exactly matches the move of the futures contract only in the last 10 days of the expiring contract. If so is it better to trade the front month option at this point or would the TVIX have an advantage since it trades as a stock and is not subject to time decay? Is TVIX any good as a trading vehicle given it recent troubles? 

clreyz1 posted April 24, 2012 (06:47AM)

"Hey Brian thanks for a eye opening article. Is it correct to conclude that the VIX exactly matches the move of the futures contract only in the last 10 days of the expiring contract. If so is it better to trade the front month option at this point or would the TVIX have an advantage since it trades as a stock and is not subject to time decay? Is TVIX or for that matter XIV any good as trading vehicles given the former's recent well publicized trading troubles? What are their risks and pitfalls?"


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