October 3, 2024
by Brian Overby
Lately, with the increasing volatility in the stock market, I’ve been receiving numerous questions about options on the Volatility Index, or VIX. Although the VIX has been around for many years, trading options on it has always had an air of mystery. VIX options are frequently used to speculate on future market volatility and can also serve as a potential hedge for your stock portfolio against sudden downturns in the overall market.
What is the VIX?
The VIX is designed to represent the market's expectation of volatility over the next 30 days. The VIX calculation uses the prices of multiple S&P 500 Index (SPX) option contracts and applies a weighted average to maintain a 30-day benchmark of the market's implied volatility. While the specific calculation is complex, the key concept to understand is how the VIX responds to market conditions. The index is often referred to as the "fear gauge" because it tends to spike during market downturns when investors are worried about where the market is headed next. In very general terms, this spike is caused by both institutional and retail traders buying SPX puts to protect their portfolios during times of market uncertainty. This increased demand for SPX options drives up their prices, which in turn may cause the SPX option contract’s implied volatility to spike, ultimately affecting the VIX. Conversely, when investors feel optimistic about the markets, the VIX generally drifts lower as multiple stocks and indexes reach new highs.
Complexities of the VIX
While the concept of market volatility may be understandable, the provisions of the contracts and the pricing of VIX options are not straightforward. The most confusing aspect of VIX options is that the VIX Index price - the value you see when you type in the symbol VIX - has little to do with the value of the option contracts. This is because the actual index is not tradable (you can’t buy shares of the index). However, there are futures contracts based on the index that are traded. Since the only tradable underlying security is the futures contract, it naturally becomes the hedge that market makers use to price the options. This creates confusion when retail investors try to determine the actual value of the volatility used to price options for a specific expiration before placing a trade on a VIX option contract. This is likely better explained with an example.
Example:
On August 26, 2024, the VIX index was at 16.44, and the September futures contract with a 9/18/2024 expiration was implying a price of 16.05. The October futures contract with a 10/16/2024 expiration was implying a price of 18.13. This is based on delayed quote data from the CBOE.com website.
As of this writing on 8/26/2024:
To complete the thought and conceptualize the example, if you're trading VIX options with a 9/18/2024 expiration, the value used for the underlying would be 16.05. For the 10/16/2024 expiration, the value used for the underlying would be 18.13. The actual VIX index value is not considered by market makers when pricing the option contracts with these expiration dates.
However, the VIX index value becomes crucial as expiration approaches because, in futures terms, the index value is considered the spot price, and the futures price ideally converges with the spot price at expiration.
Need an aspirin?
I know, I know - you might want to stop right here because that last sentence hurt your head. But if you work through the head-scratcher below, it will provide strong pain relief, and one of the final paragraphs will summarize why understanding the spot concept is essential if you want to trade options on the VIX index.
Head-scratcher:
Why is the September futures contract lower than the actual index, while the October contract is significantly higher? It’s a bit complex, but hang with me.
Let’s break it down by looking at traditional futures contracts, like those for corn or oil. Unlike options, which give the right to buy without any obligation, futures contracts require the buyer to purchase the asset at the agreed upon price when all is said and done. They were originally designed to lock in prices: imagine a farmer who wants to secure a selling price for his corn at harvest to ensure profitability. Similarly, the buyer benefits from knowing what purchase price will be in the future and can plan accordingly. The futures contract price will reflect the current asset price plus carrying costs until delivery.
Why are VIX futures weird?
VIX futures contracts are different because you can’t actually buy shares of the VIX, nor can you directly purchase the implied volatility component of the SPX option contracts on which the index is based. Since there is no physical VIX product or security to be bought and stored until a future date, there's no "carrying cost" like there is with traditional commodities. The price of a VIX futures contract is mainly influenced by many unpredictable factors, such as market conditions, recent news, and trader sentiment.
Current VIX quotes:
As for why the current VIX and VIX futures values are where they are now (see above), one hypothesis is that a significant event, such as the election in November, might be affecting the October futures. It could also be the seasonality of the markets and the VIX index over the past 20-plus years. If you look at the data, September and October have traditionally seen increased volatility compared to the other 10 months of the year. You might want to keep a lookout for a VIX index trade post based on this aforementioned seasonality data.
Options on the weather anyone?
In simple terms, trading VIX options is like trying to trade options on the temperature at some future date. For example, if the temperature in Charlotte, North Carolina, is 110 degrees on September 18th, that doesn’t help predict the temperature on November 5th, election day. While a series of 110-degree days might suggest a trend toward a warmer November, what happens on a single day in September usually has little bearing on the weather in November.
The same concept largely applies to predicting the VIX index: an unforeseen event causing significant short-term market volatility does not necessarily indicate that the market will remain highly volatile in the future. VIX futures contracts will reflect this, along with other known market events (such as a presidential election), as their expiration dates approach.
Advice:
My best advice for those looking to predict and capitalize on VIX Index swings is to stick to shorter-term contracts. Sure, this approach gives your strategy less time to be right, but these contracts will have a closer relationship to the current moves of the VIX Index, allowing you to strategize accordingly. Remember the earlier point about the VIX being the spot for all VIX futures contracts? This paragraph expands on that earlier point by explaining why it is so important and might be helpful if you want to trade VIX option contracts.
That’s it for this article on VIX Index options. The final piece of advice is to be aware that VIX options are highly speculative. Plan your risk and exit strategies accordingly.
