How to Trade VIX Options: Taking Fear Out of the Fear Index

Markets crash. And when they do, it can be fast. So, it’s a good idea to study the Cboe Volatility Index—or more affectionately, the VIX—to help you guess when that next market sell-off might happen. 

Often, the VIX is inversely correlated with the S&P 500^® index (SPX). When the SPX goes up, the VIX typically goes down. But there’s more to the VIX than this relationship. In addition to it being the market’s “fear gauge”—investors tend to be more fearful when market volatility (vol) is high, and less so when vol is low—the VIX measures the market’s expectation of future volatility implied by SPX options prices. 

The VIX has been around so long it feels like part of the scenery if you’re an active trader. But it’s a relative newcomer to Wall Street; this year, it’s celebrating the 30th anniversary of its 1993 introduction. Before 1993, market volatility was calculated using historical prices, and market participants were limited to knowing how much volatility had occurred in the past. The VIX was the first index designed to measure the market’s expectation of constant, 30-day expected volatility of the U.S. stock market. The Cboe introduced VIX futures in 2004 and VIX options in 2006.

Watch volatility closely

The VIX measures implied volatility. But what does that mean, and how is it different from other types of vol measures? There are two general types of vol: historical and implied. Historical vol is measured by what a stock or market has done in the past. If you’re looking at, say, a 20-day historical vol of the SPX, it indicates the movement of the SPX over the previous 20 days. Implied vol is a snapshot of SPX options and indicates what traders believe the future market vol may hold. Generally, as vol increases, the demand for options increases, as does trading volume. As a result, implied vol increases.  

Generally, vol rises when traders perceive higher risk in equities. So, if vol is rising, how can you trade it? Although investors can’t directly trade the VIX, they can trade VIX futures and options with the appropriate account approvals. 

VIX options: What you need to know

Before trading VIX options, you should familiarize yourself with their pricing, expiration dates, and how they’re settled. Remember: Futures and futures options trading involves substantial risk and is not appropriate for everyone.  

Pricing. Most indexes use the underlying index level to value corresponding options. However, for VIX options, the underlying is the corresponding VIX futures contract (/VX). 

VIX options and futures are priced based on forward-looking market activity. Sometimes, the /VX may trade at a premium to the VIX, and other times, the futures may trade at a discount. Basically, the level of the /VX reflects where traders believe the VIX will be at some date in the future. When futures are valued at a premium, this indicates traders believe the VIX will move higher by a certain date. When futures are at a discount, the marketplace often anticipates a drop in the VIX. This is another reason futures are used as the underlying pricing instrument for VIX puts and calls.

To see where VIX futures are trading, fire up your thinkorswim^® platform, select the Analyze tab, and punch /VX into the symbol box (see figure 1).

Say the VIX is trading at 16.15, and the VIX August 15 call is priced at 4.90. The minimum intrinsic value should be 1.15 (16.15 – 15). You may think there’s some mispricing. This is where looking at the /VX helps. Looking at the August /VX contracts, you see they’re trading at 19.85. Perhaps the calls are more reasonably priced because the August /VX contracts look to be anticipating a higher VIX than the current level.

VIX expiration and settlement. VIX options, like other index options, are cash-settled. That means, upon exercise, there’s a cash transfer from the seller of an in-the-money (ITM) option to the option owner. In the case of VIX options, this involves $100 for each point an option is ITM at expiration. For example, the holder of a 15 call would receive $500 at expiration from the holder of a short position in the 15 call if the settlement value for VIX options is 20 [(20 – 15) x $100 = $500].

VIX options are European style, so they can be exercised only at expiration. Keep in mind that holding VIX options through expiration can be tricky. VIX standard options officially expire on the Wednesday 30 days (or closest to 30 days) prior to the third Friday of the next calendar month. Although expiration is on a Wednesday, the options stop trading at the close of the Tuesday before Wednesday’s settlement. The settlement level of the VIX is a special calculation based on the opening prices of all SPX options that contribute to the VIX calculation the following day.

Keep in mind, the VIX level that results from the opening SPX options prices may differ from the closing VIX level the evening before (see figure 2). This is partly because of normal overnight activity in the global equity markets, but a number of factors may influence the actual settlement price. Also, because the VIX settlement level is determined with opening prices, it could take a few hours for the actual settlement level of the VIX to be determined. VRO is the ticker symbol for the VIX settlement price.

The final trade for /VX the Tuesday before a.m. settlement on Wednesday was 19.95. The final VIX spot index print was 19.73. The following morning, the July VIX settlement value for options positions was 18.90, 0.83 lower than the index close Tuesday evening. 

For context, a trader holding an August 20 call likely would’ve expected the call to expire worthless based on the VIX closing at 19.73 on Tuesday afternoon. But if the August VIX settlement for futures and options was priced higher than 20 on Wednesday morning, the owner of the 20 call would now receive cash for the option. That would be a nice surprise. But there’s another side—if the trader had held a short position, that option wouldn’t have expired worthless. Instead, the result of the settlement print for this trader would be a debit. 

If you have a profit in a VIX options position going into expiration, based on market conditions, you may want to consider attempting to close the position and take the profit. There may be some risk involved in holding VIX options until the settlement price is determined. Be warned.

Bearish strategy example: Buying VIX calls

Because of the inverse relationship between the SPX and VIX—especially in times of extreme negative moves in the SPX—VIX options may be used especially if you believe a downturn in SPX is likely. If you’re bullish on stocks, you might consider a bearish strategy with VIX options, although more bang for the buck typically comes when the SPX experiences a hard, fast fall. Let’s look at an example of trading VIX options with a goal to benefit from a quick pullback in the SPX.

Suppose it’s July 27, and you think the SPX is overbought at 4,400. You think there could be a dramatic pullback soon. While the SPX was rising, the VIX dropped from 41 to 19. In your opinion, stocks will fall in the next 45 days and the VIX should move to at least 25. September expiration for VIX options is 49 days off. You also note the September VIX futures are trading at 22.35—at a premium to the underlying VIX Index. Because you’re trading the September VIX options, you might use the September /VX contract as the underlying for valuation purposes. The VIX September 21 call is trading at $4.10 (or $410 per contract, which is also your maximum risk).

Fast-forward 49 days. Your market scenario turns out to be correct, and the SPX drops more than 15% to 3,740. As predicted, the VIX climbs, and VIX settlement for September comes in at 26.50. As a holder of the September 21 call, you receive a credit to your account of $550 [($26.50 – $21.00) x $100]. Subtracting the options cost of $410 nets you a profit of $140 minus transaction costs. Of course, if your market prediction turns out to be incorrect and the SPX rises, your VIX calls will likely decline in value, potentially resulting in a loss. For example, if the VIX settled below $21, you could lose your $410 premium.

Fear isn’t always bad. The VIX reflects the overall market’s opinion of how stock prices may move in the future. Often dubbed the market’s “fear gauge,” it’s more accurate to think of the VIX as a yardstick of investor uncertainty, which at times may equal fear—but not always.

The VIX wasn’t designed to predict stock prices, market direction, or market highs and lows. Instead, the VIX was created to provide an estimate of the market’s expectation of future fluctuation. And for the most part, the VIX continues to measure anticipated future volatility as designed.