VIX Options, VIX Futures, and Mini VIX Futures: Casting a Wide Volatility Net

When the Cboe Volatility Index (VIX) was launched 20 years ago, it was aimed mainly at institutional traders and options wonks. Now it’s become the proxy for assessing stock market volatility for all market participants, from the institutional fund managers all the way to the retail crowd.

And for the advanced retail trader set, there are tradable products such as VIX futures (available on the thinkorswim® platform from TD Ameritrade) that can help to further level the playing field between retail and professional traders. With the VIX, VIX options, VIX futures, and now Mini VIX futures (see sidebar below), you can increase your market awareness and make more informed trading decisions.

In other words, if you’re fishing for volatility information and trading opportunities, there’s a wide net at your disposal.   

The Volatility Food Chain

In a word, SPX options drive the VIX. The VIX (or anticipation of what the VIX might do) drives VIX futures. And VIX futures drive VIX options. 

The VIX measures the implied volatility (“vol”) of S&P 500 Index (SPX) options. The VIX is the market’s collective estimate of how much the price of the S&P 500 might move up or down over the next 30 days. So a VIX at 25.00 is interpreted as a 25% annualized level of volatility.

The VIX is calculated from the prices of out-of-the-money (OTM) SPX options. So when the prices of SPX options go up, perhaps because traders expect larger-than-typical price movement, the VIX goes up. When the prices of SPX options go down, the VIX goes down. The VIX formula takes a weighted average of the first two expiration dates of SPX options to arrive at a hypothetical constant 30-days-to-expiration volatility.

Some investors watch the VIX relative to the S&P 500. But that’s only half the picture. VIX futures are the other half.

The symbol for VIX futures is /VX. On the thinkorswim Trade tab, you’ll find the available futures going out several months, with different prices for each (see figure 1). 

When the prices of the further-expiration futures are higher than those of the nearer expiration, the term structure is in contango. When the prices of the further-expiration futures are lower than those of the nearer expiration, it’s called backwardation. For most financial futures products, contango and backwardation are determined from the “cost of carry”—the cost incurred by owning the underlying stocks or bonds.

VIX futures don’t have a cost to carry. Their contango or backwardation is determined by the market’s anticipation of what vol might be. So if you’re speculating on the VIX, don’t just look at the index. Look at VIX futures, too. Market uncertainty can create contango in VIX futures, where expectations of future market vol exceed the level of the VIX.

In late 2020, amid the coronavirus-related recession and ahead of the November election, the VIX futures term structure was in backwardation, indicating there might be less vol in coming months. Earlier in the year—before the virus hit—contango conditions were present in VIX futures, but with a “bump” around the election, which at the time was several months away (see figure 2). 

Investors may use VIX futures to anticipate higher or lower vol in the near term and adjust strategies accordingly.

Volatility Fishing Expedition

Retail traders can’t trade the VIX itself, so they often speculate using VIX options. The Trade page shows expiration dates going out roughly six months. VIX options are European-style and cash-settled, with Wednesday expiration dates 30 days prior to the third Friday of the calendar month following the expiration of VIX options. (To see the VIX settlement value, use the symbol “VRO.”) It’s confusing, so the expiration dates are clearly labeled for you in the option chain of each series.

Sometimes VIX options prices don’t make sense relative to the VIX. Why? Because of the golden rule of market making—price options off your hedge. As market makers buy and sell options, they hedge trades to avoid directional (delta) risk. If you make markets in VIX options, and you can’t trade the VIX itself, what’s your hedge? Bingo—VIX futures.

That’s why VIX options look at the prices of VIX futures to determine pre-expiration value, not the VIX itself. And that’s why the ability to easily view VIX futures is exciting. thinkorswim is one of the few retail trading platforms to offer VIX futures, which helps to make VIX options pricing more transparent. Figure 3 shows you how.

With the VIX at 28.91, the call strikes with 68 days to expiration are trading higher than those with 96 days to expiration.

But aren’t options at the same strike with more days to expiration supposed to have a higher value than options with fewer days to expiration? Yes, if you’re looking at equity options. But VIX options in a particular expiration are priced off the VIX futures with the same expiration. So if you’re looking at December VIX options, those are priced off December VIX futures. And because of contango or backwardation in VIX futures, the VIX options may look mispriced if all you’re looking at is the spot VIX. (Remember the term structure in figure 2.)

Casting the Volatility Trading Net

Looking for actionable VIX strategies? Depending on market conditions, VIX options, VIX futures, and Mini VIX futures can be used not only to help inform your trading decisions, but also to speculate and hedge directional and volatility risk. 

1. Bullish or bearish on volatility? Account owners with futures approval can buy and sell /VX  and /VXM, with all the benefits (and risks) of margin.  
2. Looking for “mean reversion” or “trend continuation?” Think about the S&P 500. If the S&P 500 has been rallying and pushes the VIX lower, a contrarian trader might believe the VIX is due to bounce. Bullish strategies to consider might include a short put or a long call vertical spread in VIX options, or a long or short position in VIX futures.
3. Is the tail wagging the dog? Sometimes the stock market direction moves the volatility market (typically in the inverse direction). But sometimes the volatility market—specifically the VIX and the term structure of VIX futures—offers clues as to stock market expectations. Follow the trends and expectations priced into the futures market to help your stock trading decisions.

When taken at face value, the VIX—that single snapshot of implied volatility—is a pretty straightforward concept. When uncertainty rises, so does VIX, typically. But add in a couple nuances (VIX options are volatility products based on a volatility index and VIX futures are volatility expectations at various points in the future based on an index of volatility expectations today) and it can be a bit much to take in. As any fishing fan will tell you, patience—and knowing when and where to cast the net—can help you land that big one.