Trading the VIX

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Hello again, Sleuths,

I’m pleased to report to you today that my recent columns on volatility and the VIX have generated some interest. That’s great!

After all, my purpose in authoring this column is to help you think about trading and investing in a different way than you may have done previously. In applying some of the concepts I discuss and in using certain indicators I’ve described, you can search for additional ways to let your profits run, protect your capital, and uncover new trading and investing opportunities.

Along these lines, let me share with you an e-mail I recently received from one of you Sleuthers:

“I would be interested in reading an article about how to buy the VIX for a long-term holding. I realize the VIX is more about a 30-day timeframe, but I noticed earlier this year that the CBOE announced the ability to buy long dated options. The problem is they dont behave like I originally thought.

“A call to my broker prior to a purchase wasnt of much help either. So I dabbled with a single option to see how things would work out. I made money, but I dont like how it works. I realize SPY is another choice, but is there a better approach for buying the VIX and holding for a year or two?”

This Sleuther is correct. If you are interested in trading or “investing” in volatility through the VIX, you can avail yourself of options based on the indexes that trade on the Chicago Board Options Exchange (CBOE). Those options first began trading earlier this year.

I do not know what this Sleuther was referring to in commenting on how the option behaved. But if you are interested in buying or selling options on the VIX, a number of the strike prices have a large amount of open interest. Therefore, liquidity should not be a concern. So, if you are looking for a directional play on volatility and particularly on volatility levels on the S&P 500 you can consider the new VIX options.

Now, this Sleuther is also correct in that the VIX is calculated based upon a 30-day timeframe. So, even though there are longer-dated options available for trading the VIX, the intrinsic value of those options are based upon the VIX index itself, which is calculated through the use of options with an average timeframe of 30 days. But keep in mind that the VIX’s 30-day timeframe is continually updated. That updating does tend to mitigate the short-term nature of the VIX’s value, and enables you to consider volatility in a longer timeframe if you have a conviction regarding the long-term direction of volatility.

I should make one other point about the 30-day timeframe: Because of this timeframe, the expiration and settlement rules regarding the VIX options are different from most other equity options whose underlying security is an individual stock or an exchange traded fund (ETF).

Although I am oversimplifying things a bit, most options whose underlying asset trades on the American Stock Exchange (or any other exchange) conclude trading on the Friday of the expiration week. Due to the 30-day timeframe, the rules for the VIX options are a little different.

In order to conform the VIX’s 30-day time period within the confines of each month’s options expiration week, the VIX options conclude trading on a Tuesday and settle on a Wednesday. If the following options month is a four-week month, the VIX options will conclude trading and settle on the Tuesday and Wednesday prior to the Friday options expiration for most options. Conversely, if the following options month is a five-week month, the VIX options will conclude trading and settle on the Tuesday and Wednesday of the week following the Friday option expiration day for most options.

www.cboe.com/.

September 20, 2006

October 18, 2006

November 15, 2006

December 20, 2006

If you do not wish to trade options, you can take a look at the futures market. On March 26, 2004, the CBOE Futures Exchange (CFE) launched a futures contract based upon the value of the VIX. The VIX futures contract is based upon a price that is 10 times the expected value of the VIX Index. Thus, a November 2006 VIX futures contract with a value of 132.00 implies a forward VIX level in November of 13.20. You can find plenty of information and on the VIX futures contact at the CBOE website.

Trading a VIX futures contract with a distant expiration month would allow you to establish a position with a longer view regarding the direction of volatility. If you are concerned about being exposed to margin calls and the substantial risk inherent in futures trading, you could use the VIX options, in conjunction with a VIX futures position, to create a strategy that would lead to a profit if your directional call on volatility is correct, while limiting the risk in futures trading. You might wish to consult a knowledgeable futures broker to help you out.

But what if you don’t wish to get involved in futures? Is there any other way to establish a long-term position based upon your assessment of the direction of volatility?

The short answer is no, at least not at the present time. I say “not at the present time” because it seems as if a new ETF is created nearly every day that focuses on a specific area or facet of the stock market. I am not aware of any currently trading ETF that is based strictly on volatility. However, I wouldn’t be the slightest bit surprised to see one in the not too distant future.

Given the negative correlation between the movements in the VIX and the S&P 500 Index that I have pointed out in prior Sleuth columns, as the Sleuther mentioned earlier you can use the S&P 500 Depository Receipts (SPY:AMEX ), a proxy for the S&P 500 Index, as a way to take a stand on volatility. However, that’s not a “pure play” on volatility, but rather a trade or investment you can initiate based upon the information you have gathered from monitoring the VIX.

And that was my purpose in discussing volatility in earlier essays. By keeping an eye on the market’s volatility levels, you have an additional weapon at your disposal when making trading and investment decisions. So, for now, unless you are willing to wade into the options or futures markets, think of the VIX as part of your technical arsenal. And when dealing with the financial markets, it never hurts to have as large an arsenal as possible at your disposal.

Trade well,

Mark Bail

August 22, 2006