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With VIX Options, What You See Isn’t Always What You Get

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January 1, 2016
capiche VIX options
Fredrik Broden

Most of the time traders turn to the CBOE Volatility Index (VIX) to check the pulse of the market. And many options traders naturally gravitate to VIX options to trade their opinion on volatility. But buyers (and sellers) beware—there’s a chance you’re watching apples to trade oranges.

Options traders know that options prices are based, in part, on the current price of the underlying. But options prices are also partially based on the anticipated future value of an underlying until expiration, once interest rates and dividends are factored in. Yet, even though the VIX is just a number or a kind of benchmark that can’t be traded (and certainly doesn’t pay dividends), the same idea applies here. But, with a twist.

The Future Is Now

The VIX measures the volatility of the S&P 500 (SPX) options. And volatility is something that’s known as “mean-reverting.” That’s a fancy way of saying the VIX is likely reverting to its normal range. Not always. But much of the time.

But here’s the twist: the VIX represents the current “cash” value of its options, similar to the current price of a stock. But options aren’t priced off the cash market, right? They’re priced off where the VIX is projected to be at option expiration, which is the future value.

So notice what happens when an event spooks the market. The VIX itself pops because it represents a “right this minute” level of fear. Sooner or later, though, things typically return to normal. How soon? Enter: VIX futures.

In this instance, a cash value of VIX is higher than a future value. This difference in the two numbers represents the market’s way of handicapping the likelihood of things settling down. The greater the disparity, the more likely it is that the VIX will be back to normal by expiration.

As expiration gets closer, the cash and futures converge. By expiration, they’re the same. So as time passes, something has to give. Either the VIX starts to settle down, or, if market fear remains elevated, the price of the futures has to rise to meet it.

Look for yourself. You can explore the chart of VIX futures on the thinkorswim® platform by TD Ameritrade using the symbol /VX. If the jump in volatility is expected to be short-lived, VIX futures won’t go up that much. If VIX futures don’t go up, neither do VIX call options. This explains why there can be a disconnect between a spiking VIX and call options that might not move.

Manage Expectations

How can this affect your trading? First, don’t expect a point-for-point move in the futures. Second, shorter-term options are impacted more, and longer-term options are affected less because there’s more time for things to settle down. And third, if your VIX call options have profited, keep in mind your calls are likely to collapse once there’s any hint of safety.

Remember: with VIX options, you’re not trading current volatility. You’re trading the expectation of future volatility levels.