In our previous article on volatility measurements, we detailed how options are not only tradable securities but also indicators of market sentiment.
As a reminder, the price of an option fluctuates not only due to movement in the underlying security but also due a change in implied volatility, which is the market’s anticipation of the magnitude of future price movement.
Indices like the VIX were created to track changes in the volatility value of options that essentially reflect changes in the market’s perception of risk. Importantly, some of these indices are also available as tradable products - meaning investors can take/hedge risk in their portfolios with such instruments.
Today we are digging deeper on the VIX, or CBOE Volatility Index, which is one of the most frequently cited volatility indices in the investments industry.
The VIX represents a theoretical weighted blend of prices on a range of OTM options in the S&P 500 index. The value of the VIX index therefore changes with the demand for these options, which is why it is said to reflect the market's appetite for risk.
If the extrinsic value of OTM options increases due to demand, the VIX will go higher. If the extrinsic value of OTM options decreases to a drop in demand for the option, the VIX will go lower.
The above represents effectively how the VIX went from theory to practice. It’s important to note that while traders can’t trade the actual VIX Index, they can trade VIX futures and VIX options. In terms of practical application, VIX futures and VIX options can be used in a variety of ways.
For example, if a trader has sold premium in high IV options across a group of single stocks or ETFs, he/she might consider buying VIX futures to hedge their overall portfolio. This might be particularly attractive if VIX IV is cheap and/or if the absolute level for VIX is historically low.
Under this scenario (short premium portfolio, long VIX futures), an increase in volatility would put pressure on the short premium stock/ETF options, but a likely increase in the value of the VIX futures would help mitigate those losses. In the reverse scenario, in which volatility decreases, the profits from short premium in stocks/ETFs would outweigh (if scaled appropriately) any losses in the VIX position.
It should be noted that there is not a generally accepted mathematical relationship between the spectrum of months in listed VIX futures - which is why calendar spreads in this instrument are not recommended.
To learn more about the VIX and how it can be used, we recommend you watch this episode of Market Measures.
In the final segment of this 3-part series, we’ll be providing further details on the VIX and several other commonly traded products in the “pure” volatility sector.
In the meantime, please don’t hesitate to reach out if you have any questions or comments at firstname.lastname@example.org!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.