An Explanation of VIX Options

I’ve been discussing the VIX as a proxy for market volatility, and as a hedge against a crash. Some people have complained that the ubnderlying options — especially the longer dated calls — do not move in parallel with the VIX.

Part of the problem is the tendency for the VIX to snapback to prior levels after a spike.  Trading these options successfully requires a trifecta of sorts: You must get the direction, level and timing pretty close to precisely correct to get the maximum return.  Its tricky.

Barron’s Kopin Tan goes into the details:

"[VIX Option] Volume has soared since these were introduced in February, with 1.02 million VIX calls and puts trading in May — up from 285,994 in April. Yet they leave many investors perplexed.

For a start, because VIX peeks only 30 days ahead, its current reading can differ substantially from its forward value. Case in point: Even as VIX climbed toward 19 early last week, futures prices pointed to a more subdued VIX, at about 16 come November — a sign the market expects the current volatility spike to moderate in time. This is logical, since projected volatility tends to jump sharply and then ebb gradually, and premiums soared recently in part because so many option sellers had scrambled to cover their short-volatility bets."

But its more than that; the way VIX options get exercised have an impact on their trading:

"VIX options can only be exercised upon expiration. So a big jump in the VIX may not move longer-term call prices — if the market expects that jump to be fleeting. In other words, VIX options may not mirror real-time readings, although any divergence will decrease as options approach expiration. As a portfolio hedge, "buying VIX calls only helps in a crash right before expiration," says Tom Sosnoff, CEO of the brokerage firm thinkorswim Group.

Instead, those who expect volatility to increase — or at least not to decline — might be better off selling VIX puts, Sosnoff says. Because VIX options trade at strike-price increments that are 2.5 points wide, investors have a limited choice of what they can sell; and the situation will not improve until more flexible, one-point wide strikes are introduced.

But the VIX has swung dramatically from one day to the next, and is at its most volatile in years. Premiums from selling VIX options are thus high — for a reason. Because volatility can never fall to zero, and VIX has rarely fallen below 10, a seller of VIX puts has downside risk that is capped to a certain extent."

For high risk tolerant traders, instead of buying calls when cheap, the alternative strategy is selling out of the money puts:

"Still, the average investor might want to wait for the wild VIX swings to stabilize before looking to sell out-of-the-money puts. The premiums earned provide only a partial hedge against a market crash, but a careful seller of VIX puts can earn steady income over time — especially if the stock market becomes more volatile."

This is not for rookies, and investors should make themselves aware of the attendent risks and exposure of this . . .


UPDATE:  June 12, 2006 9:43am

Steven Smith asks "Is the VIX a ‘Fraud’?"

"An article in Barron’s this weekend discusses how VIX options don’t work too well for hedging against a market decline. It goes as far as quoting a reader who claims "this product is a fraud," referring to the fact that despite a nearly 70% increase in the VIX over the past four weeks, the value of November $15 calls have gained only about 20% during that time.

In previous posts I’ve discussed the two main reasons for the seeming lack of leverage or correlation: First is the fact that the options are priced and settled against VIX futures, not the cash or spot VIX index; second, as an instrument that has a tendency to revert to the mean, the futures will tend to discount moves, especially anything to what is viewed as an extreme level. This creates a dampening effect on options price movement.

The conclusion is that it will take a large crash very near expiration to see the price of calls really kick higher. Instead, as I’ve suggested before, it is better to sell puts on the notion that volatility can’t go to zero and historically the 10% level has pretty much been a floor, meaning the risk of an implosion which would cause a spike in put prices is minimal."


Vexed by the VIX
Barron’s Monday, June 12, 2006

"Is the VIX a ‘Fraud’?"
Steven Smith
Real Money, 6/12/2006 8:35 AM EDT

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