An In-Depth Look at VIX Options
A VIX option is a non-equity index option that employs the S&P 500 Volatility Index as its underlying asset.
Key Highlights
- Underlying Asset: VIX Options trade based on the S&P 500 Volatility Index.
- Natural Hedge: VIX call options serve as natural hedges against market downturns.
- Challenges with Puts: VIX put options can be more complex due to the usual patterns of the S&P 500 index.
- European-Style Trading: VIX options trade as European-style options.
Exploring the Mechanics of VIX Options
Both call and put VIX options are available in the market. Call options effectively hedge portfolios against abrupt market drops, while put options offer protection against a swift reversal of short positions in the S&P 500 index.
Introduced in 2006, VIX options were the first exchange-traded options allowing individual investors to trade on market volatility. By purchasing a VIX call option, a trader can profit from sudden spikes in market volatility, which often occur alongside short-term stock price shocks and downward market trends.
The calculus for the VIX involves slow decreases followed by rapid volatility surges. Consequently, VIX call options, when strategically timed, act as an effective hedge. However, leveraging VIX put options requires accurate market trend prediction.
Furthermore, VIX options, trading exclusively in cash and in the European style, limit the exercise of the option until it expires. Traders can sell an existing long position or purchase an equivalent option to close a short position before expiration.
Sophisticated and advanced traders also utilize various strategies, such as bull call spreads and butterfly spreads, to optimize their position in VIX options. However, techniques like calendar spreads may face challenges since differing expiration series do not align as closely with equity options counterparts.
Understanding the VIX
The Volatility Index, often referred to as the VIX, trades under the symbol VIX with the Cboe Global Markets. Unlike traditional traded instruments, the VIX represents the market’s expectations of 30-day volatility in the stock market, not the price of a commodity, interest rate, or exchange rate.
To estimate the VIX, a calculated index based on the price of options on the S&P 500 is used. This methodology estimates the volatility of these S&P options from the current date to the option’s expiration date, with the Cboe aggregating the price of multiple options to derive an overall volatility value.
Introduced in 1993, the VIX was initially a measure of implied volatility of eight S&P 100 at-the-money put and call options but expanded in 2004 to include a broader index— the S&P 500. This expansion more accurately captures investor expectations regarding future market volatility. VIX values exceeding 30 typically indicate high volatility due to widespread investor anxiety or uncertainty, whereas values below 15 signify less stress and a more complacent market.
Due to its pronounced movements during periods of market fear and uncertainty, the VIX is often termed the ‘fear index.’
Related Terms: Cboe Volatility Index, Options Trading, Hedging, Market Volatility, European Style Options.
References
- Cboe Global Markets. “White Paper, Cboe Volatility Index”, Page 3.
- Cboe Global Markets. “White Paper, Cboe Volatility Index”, Page 5.
- Cboe Global Markets. “White Paper, Cboe Volatility Index”, Page 4.
