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Volatility Update: Weekly Options on VIX; Plus Low-Vol Calendars

August 13, 2015
Volatility update

Editor’s note: Today’s column launches a weekly look at broad market volatility and other options market measures that can help traders get a reading on the stock market’s mood. Plus, each week, RED Option’s Tom White will present an option strategy that may fit current conditions. As of October 3, 2016, RED Option is now TradeWise.

The Chicago Board Options Exchange (CBOE) on October 8 will launch weekly options on the CBOE Volatility Index (VIX). It’s a new spin on an old product (WeeklysSM Options from CBOE) that will, quite literally, offer a lot more options for traders who are looking for exposure to volatility in the U.S. equities market.

Of course, VIX Weeklys come with their own set of risks and fees to weigh. Weekly options on VIX tighten the trading horizon. Their timing could be embraced by traders who think that a broad stock market that’s teetering near record highs is looking vulnerable.

Indeed, investor interest in options on volatility typically increases during times of rising anxiety levels and when stocks face bouts of selling pressure. For instance, the single-day record for trading in VIX options was set on February 3, 2014, when 2.3 million contracts changed hands and the index hit multi-month highs. More than 1.8 million contracts—or 80% of the activity that day—were call options.

Call buyers normally take positions when they expect the price of the underlying asset to increase. The volatility index typically moves higher when stocks come under pressure because it tracks the implied, or “expected,” volatility priced into S&P 500 (SPX) options. In short, VIX is designed to reflect investors' consensus expectations for 30-day stock market volatility. And when nervous portfolio managers scramble to protect portfolios with put options, the increased demand typically drives up the premiums of SPX options and VIX moves higher. When implied volatility rises, risk “premiums” rise. In very simple terms, VIX indicates whether premiums are increasing or decreasing.

It’s important to keep in mind, however, that the volatility index captures premiums only for short-term SPX options. In a normal market, such as VIX’s churn around 14 in early August (see figure 1), the shorter-dated options on the SPX typically trade at lower levels compared to longer-dated contracts. 



This term structure is called “contango.” The upward-sloping line reflects greater uncertainty about volatility over a longer-term time frame than in the more visible short term. Source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

Although portfolio managers and other institutional investors sometimes turn to VIX call options to help hedge the risk of volatility spikes, purchasing longer-dated VIX contracts is not without risk. Namely, if volatility doesn’t move higher, the options can lose value due to time decay and the nature of the term structure of SPX options. As time passes, longer-term options become short-term options and move steadily lower along the curve.

In fact, volatility spikes often impact short-term SPX options more than longer-dated ones. For instance, consider the term structure of VIX options one month ago when the SPX suffered a series of losses and volatility jumped to multi-month highs. The VIX term structure shifted into “backwardation,” where the very short-dated July options traded at higher levels compared to August, September, and even October before resuming an upward-sloping trend.



This VIX snapshot from early July shows near-term VIX much higher than VIX levels estimated for August through October. It’s a term structure shape called “backwardation.” Source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

Keep in mind that weekly expirations for VIX have unique characteristics. The options settle on Wednesday rather than Friday, and options premiums are derived not from the index itself, but from forward values computed by the CBOE.

Still, proponents will argue that since short-dated VIX options can offer more “bang for the buck” during times of market turmoil, VIX Weeklys could attract strong trading interest when the equity market becomes unsettled. At least, that’s what the exchange is banking on, and so are traders who think this stretch of low broad market volatility is merely the calm before the storm.

Tom White’s RED Option Strategy of the Week

Want to sniff out option opportunities in range-bound, low-volatility stock markets? Maybe take advantage of time decay across different expiration cycles? Do you like the idea of defining risk? A calendar spread, also called a time spread, is often used toward these goals.

The trade’s two “legs” can be directional or neutral based on the strike price in the position.

Calendar spreads earn their name because they involve options in two different expiration cycles or series, with the options either both calls or both puts. Calendar spreads involve buying an option in one expiration cycle and selling another option in a different expiration cycle but with the same strike as the first option. A long call calendar spread is selling a call in a near-term (or front) series at a certain strike, and buying a call in a longer-term (or deferred) series at the same strike. A put calendar spread is selling a put in a front cycle at a certain strike, and buying a put in a deferred month at the same strike. Both of these positions are considered risk-defined because the price paid for the calendar is the amount you can potentially lose (plus transaction costs).

Many traders consider the ideal scenario for a long calendar is an underlying trading at or near the strike price. Time decay, or theta, is higher in short options, which in turn expands the calendar value as you get closer to expiration. This strategy potentially works best in market environments where the underlying shares remain near the strike selected, and the initiation price is less expensive when volatility is low. More next week on short calendar spreads.

Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.  

Because they are short-lived instruments, weekly options positions require close monitoring, as they can be subject to significant volatility. Profits can disappear quickly and can even turn into losses with a very small movement of the underlying instrument.

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