Doc Maher discusses a key difference for Darylrs' trade.
I'm not sure of what you were saying in your trade note about buying VIX calls, but let me use this as an opportunity to make a few comments. Before we begin, let's define the VIX for everyone's benefit. The VIX measures the Implied Volatility of the S&P 500 index. To read more about some important characteristics of VIX options, please read Brian Overby's blog Vix options and expiration. Be sure to catch the comment section too.
Your trade: Bought to Open VIX HX at 2.00
Your note: "Expect increased volatility at options expiration. Hedge against an uptrending market."
I do not know exactly what you mean you say "expect increased volatility at expiration." Are you saying that you expect higher market Volatility or increased Implied Volatility on the S&P 500? Increased market Volatility is certainly possible and you may have any number of reasons to expect that, however I don't know of any correlation between expiration and increased Implied Volatility.
Click here for a larger image.
As you can see from the above VIX chart there appears to be no correlation between the VIX and expiration dates.
However there is a correlation between the VIX and market movement. Rising SPX (S&P 500) usually means falling VIX and falling SPX usually is followed by rising VIX. See below:
Click here for a larger image.
So buying a call on the VIX as a hedge against an up trending market would not be expected to provide any protection, in fact it may make things worse. The more the market trends up, the lower we expect the VIX to go.
I answered a question from an earlier blog Options - wrapped up like a "Pretzel": trying to explain why this happens and I'll repeat it here.
"When I have a stock that is going down I just sell it. However there are large holders of the stock that can't dump the millions of shares that they own. These institutions can only try to hedge their positions by buying puts. Since the demand for puts goes up, so does the price of the puts, and that's reflected in the Implied Volatility (IV). It's a little like trying to buy insurance. When it's a sunny day the price is the normal price but when a big storm is coming the insurance company may perceive a greater risk and raise the price. That's basically what the Market makers are doing. When you buy a put the market maker is taking on risk and they need to be compensated for that."
This happens not just on individual stocks but on the market as a whole. If you look at the VIX, you will see that whenever the market drops, the VIX goes up. This is indicating that options in general are getting relatively more expensive.
Thanks for your comments.
"Income Trader"
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This comment and any market data included here were completed on 5/16/08.
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 or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
