So You Want To Trade Options/Getting Your Feet Wet

Understanding the CBOE Market Volatility Index

Elizabeth Harrow (eharrow@sir-inc.com)

In this article, I’m going to pontificate about what just may be the most closely watched sentiment indicator in the market: the CBOE Market Volatility Index (VIX). Much is made of fluctuations in the VIX in various financial media outlets, but how much do you really know about this nifty little index? To learn more about what the VIX is, how it’s calculated, and what this all has to do with options, humor me by reading on.

The nuts and bolts of the VIX

Forgive me for assuming, but I bet there’s a good chance that you’ve heard the VIX referred to as the fear gauge. This is all well and good, and it gives you a vague idea as to what on Earth you might be looking at — but this description is oversimplified at best, and cruelly reductive at worst. It’s somewhat akin to describing William Shakespeare as a dude who liked to wear frilly collars.

As the name implies, the CBOE Market Volatility Index (VIX) was created by the good people at the Chicago Board Options Exchange (CBOE) . The VIX was launched in 1993 in order to track investors’ expectations for short-term volatility in the stock market. For the first 10 years, the value of the VIX was derived from the implied volatilities of eight different at-the-money S&P 100 Index (OEX) options.

However, CBOE completely revamped the VIX in 2003. Now, the index is based on the prices of a wide variety of S&P 500 Index (SPX) options, and the prices are weighted to offer an outlook as to what investors are expecting from stocks during the next 30 days. Rather than concentrating exclusively on at-the-money strikes, the VIX now takes into account a broader range of strike prices — as well as a broader range of equities, via the SPX. (You can still track expected volatility for OEX by checking out another of CBOE’s volatility indexes, the VXO.) Additional information can be found by checking out the VIX White Paper .

What does all this mean for you? Here’s the deal: rising implied volatility is generally associated with bearish price action. When investors are anticipating major downside in the stock market, volatility will creep higher. Conversely, when bullish price action is expected, volatility levels generally remain very tame. (Note my liberal use of the word generally here — on an equity-specific basis, implied volatility can also be influenced by scheduled events, such as earnings reports.)

So, at the most fundamental level, rising expectations for bearish price action will result in higher implied volatility on SPX options, which will then translate to an increase in the VIX. This is where the delightfully basic fear gauge descriptor comes in. If investors are feeling more fearful of a market crash (or dip, or pullback, or correction), the VIX will theoretically rise. Conversely, expectations for bullish price action in the broad market should usually result in a dip for the VIX.

In light of this, you might expect the VIX to move directly inversely with the SPX — but that’s not the case. Remember, rather than tracking the actual price action of the market, the VIX tracks investors’ expectations for the market during the next 30 days. In other words, we’re only measuring changes in Wall Street’s mood with this tool. Because of this, the relationship between the two indexes could more accurately be described as vaguely inverse.

As a caveat, it’s not unusual to see a big spike in the VIX on major down days for the SPX. That’s because a single-day sell-off can spark increased anxiety among investors, thereby pushing implied volatility — and short-term SPX option prices — skyward. But on more typical trading days, with less dramatic price changes, the movements of the VIX relative to the SPX are harder to predict.

What does this have to do with options?

In case you hadn’t noticed, CBOE is a major player in the options arena (to make a terrible joke, you could even say that options are their middle name. Sorry). So, it was only a matter of time before they rolled out option contracts based on the VIX itself. These volatility-based derivatives were first introduced in 2006.

If you’re looking to trade volatility, VIX options could be an ideal vehicle for you. But there are a few quirks you need to know about before jumping into a trade. For starters, VIX options are not based on real-time VIX values, the way that a traditional put or call will take its cues from the price action of its underlying equity. Instead, the underlying equity for VIX options is the forward VIX, or the group of SPX options that will be used to calculate the exercise settlement value at expiration. So, you’ll get a better idea of what your option price is based on by checking out VIX futures, rather than the current price of the VIX.

To make this a little easier to swallow: VIX options expiring in January are based on the implied volatility of February SPX options, making them something of a leading indicator. This disparity is a bit of a mind-boggler at first, but it’s in keeping with the VIX’s mission of reflecting the market’s expectations for volatility during the next 30 days.

Additionally, due to the unique manner in which the index’s value is calculated, VIX options don’t expire on the third Friday of the month, like equity options do. Instead, VIX options expire on the Wednesday 30 days prior to the third Friday of the following calendar month. (This is usually the third Wednesday of the month, but not always. In July, VIX options expired on the fourth Wednesday, due to the way the calendar fell.) This unique expiration date makes it easier for CBOE to calculate the exercise settlement value of the options, since the VIX’s value on this date will be entirely comprised of SPX options expiring in exactly 30 days.

Because of these factors, keep in mind that VIX options aren’t the best way to make a pure, speculative bet on bullish or bearish price action in the SPX. If that’s what you’re looking to do, you’ll likely be better off trading puts and calls on the SPDR S&P 500 (SPY) exchange-traded fund. Instead, use VIX options if you’re interested in making a pure, speculative bet on volatility. To put this in slightly plainer language: if you’re expecting mass hysteria in the market, go ahead and buy a VIX call.

Also, think twice before using VIX options as a portfolio hedge. As I mentioned earlier, the index does not typically move in a directly inverse pattern to the SPX. Plus, remember that VIX options are based on the forward VIX, which doesn’t always register the same drastic daily volatility that the spot VIX does. So, even if the market tanks on Friday and the VIX spikes, that doesn’t necessarily mean your VIX call option will see a big jump in value.

After beating around the bush for most of the last two pages, I’m going to come right out and say that VIX options are probably not ideal for beginning option traders. It requires a pretty high-level understanding of volatility, the stock market, and the VIX itself in order to trade these contracts with confidence. However, don’t let that stop you from learning more — as you might imagine, CBOE’s Web site is the perfect place to continue your education.