The VIX and its Derivatives
This is the 2nd in our “Journey to Vol Trading” series that chronicles the evolution of our trading. Keep reading for updates.
Before we continuing chronicling the development of our models and trading, it’s important to step back and review some of the core concepts that are necessary to properly understand the volatility market and, eventually, trade it profitably.
The S&P 500 Volatility Index (VIX)
There are many ways to trade volatility, including options on individual stocks (part of our early strategy described previously). The volatility of indices, we find, is more predictable and easier to model. While there is a volatility index for the Dow, Russell and other indices, the oldest and most developed is the VIX, which simply measures the volatility of the S&P 500 index by looking at a series of options (both puts and calls) on the index. The actual calculation has been updated over the years, and is relatively complex. It is described in great depth, with a plenitude of maths, in this excellent article by Magma Capital Funds.
To keep things simple for our discussion, the VIX essentially models how expensive 30-day options on the S&P 500 index are, and is a measure of the average implied volatility of the index’s options at that time.
How the VIX reacts to market movements
The implied volatility of individual stocks depends on their price movements, and that is true for the VIX as well. In general, when the S&P 500 index falls, the VIX rises. Conversely, when the S&P 500 rises, the VIX will start to fall.
This behavior is driven by the need for investors to buy protection for their portfolios (for various reasons it is easier and more tax advantaged than selling the entire portfolio and re-buying it later). When the S&P 500 index is falling, a good way to protect a portfolio from further losses is buying puts on the index. As demand for puts goes up, their prices do as well, and the VIX rises. When the market has fallen, there are also speculators that buy calls, hoping for a quick profit if it bounces back. Rising call prices further contribute to an increase in the VIX.
After the market has rebounded and stabilized in an uptrend, investors stop buying puts, and speculators stop buying calls since they don’t expect large moves upwards. Since options that expire “out of the money” lose all the premium, once the expectations of quick movements subside, options buyers quickly lose interest and stop buying them. Option prices fall, and so does the VIX.
There is always some demand for options, since many investors like to keep some protection at all times (like insurance), so the VIX never goes to 0. Historically, when the market is going up steadily, the demand for puts and calls stabilized around a value of 10–15 on the VIX.
While the basic behavior of the VIX is simply tied to the S&P 500 price movements, there is a myriad of nuances that further affect the price. For example, let’s say the S&P falls 10%. If this drop happens in a few days, vs gradually over a few months, the VIX reacts differently (fast drops result in higher VIX).
In addition, macroeconomic factors also play into the VIX’s movement. The market may be stable, but an impending Federal Funds Rate decision will cause investors to buy up puts (or calls) since they expect a big movement after the announcement. Therefore, the VIX can get elevated even in a flat market.
While the behavior of the VIX is complex, there are overall easily discernible patterns that are evidence in the chart above that refelcts its 30 year history.
- The VIX is mean reverting: While it has occasional spikes, it consistently settles to a base value between 10–15
- The VIX can rise sharply in a short time: The calculation of the VIX causes its value to jump quickly during market turmoil, rising over 400%+ in a matter of days on multiple occasions
- The VIX falls quickly after spiking: Market panic generally subsides quickly, even in scary times (2008 Financial Crisis, 2020 Covid etc) so we don’t expect the VIX to stay high very long.
How to Trade the VIX
The most important aspect of the VIX is that it cannot be traded itself. Because it is an index, it is just a number. Of course there are ways to trade based on the expectation of that number’s value at a certain point in the future, via options and futures. These are called “derivatives” because they are derived from the underlying index.
VIX Options
Like the options on the S&P 500 index (which the VIX is based on), the VIX itself has a series of options.
The challenge with VIX options is that they are priced very differently than options on other indices or stocks.
- Firstly, because the VIX moves so much and so quickly, its options are extremely expensive, due to a very high implied volatility. For example, with the VIX at 21 (meaning an avg 21% IV in the S&P 500), the options on the VIX options have an IV of 70–80%. This means that buying VIX options is usually a losing proposition, unless you happen to time it perfectly right. On the other hand, selling them works well (due to collecting large premium), until the VIX explodes through the strike price resulting in extreme losses. Trading VIX options poses the same issues we encountered in the beginning while trading options on individual high IV stocks. It is certainly not for the faint of heart.
- Second, VIX options incorporate the “mean reverting” concept. This means that when the VIX is high, the put options become much more expensive, because everyone is expecting the VIX to fall. And while the VIX is low, the Call options are pricey, because it is known that eventually it will spike.
These two challenges make it very hard to design a strategy for trading VIX options, because it has to outperform the IV (market’s expectations) of the VIX while managing the outsize risk of either long options (large premium losses) or short options (large capital losses when VIX moves the options ITM). In addition, the complexity of option chains (multiple expirations, calls vs puts, multiple strikes, and wider bid-ask spreads on each option) makes it much harder to test strategies in a systematic way.
VIX Futures
The second way to trade the VIX is through futures. Like all index futures, these are cash-settled. The future is simply a contract to pay or receive a certain amount of cash based on the value of the VIX at the future’s expiry.
Let’s say you buy a VIX future today for $30 and the VIX is at 25. You are counting on the VIX rising above $30 by the time the future expires. If it stays below, you pay the difference, while if it goes above you receive that difference in profit. Unlike options, futures don’t have a “premium” in the traditional sense. Whatever you pay for the future is your cost, and the final price at which the future settles is your “sale” price, which determines your profit or loss. Like options, you can also sell futures, which is the inverse where you are looking for the VIX to end at a price below the price at which you purchased the future.
VIX futures trading is more attractive than options, because it requires less precise timing and avoids the extreme outcomes of options (total loss of premium if long the option, or large loss of capital if short the option). Futures are also simpler because there is only one or two main tradeable contracts (usually the current “front” month, and the next “back” month”) instead of option chains with hundreds of possible options to buy or sell. Lastly, the bid ask spread is always $0.05, which is less than most VIX options and always less than options on a % basis (i.e $0.05 of a $30 future contract is less slippage than $0.05 on a $2.00 option)
However, VIX futures have their own nuances and challenges, which we will explore in our next article …..
*** As always, we make it very clear that this is not investment advice, none of us are allowed to provide investment advice, this is research work product only and any trading decisions should be made on your own based on your own research and trade ideas **********
