There are many volatility products that are derived from or correlated to the VIX. Understanding the relationship between these products can help identify their pros, cons, and risks.
Market volatility. It can conjure fear in the unprepared but create potential opportunity for the seasoned trader. Volatility (vol) has been around for as long as humans have been thinking about the price of things, maybe even before money. Whether it’s our cave-dwelling ancestor’s new stone tool valued in terms of a pile of sweet berries, or our neighbor’s new hot rod priced in dollars, values change in unpredictable ways. That’s volatility.
Vol is simply the magnitude of changes in price—whether it’s a stock, index, your house, or a loaf of bread. For example, if one loaf of bread costs $2 the first day, $3.50 the next day, and $0.20 the day after that, and another loaf of bread costs $2.50 the first day, $2.60 the next day, and $2.55 the day after that, we’d say the first loaf of bread is more volatile. The same is true for two stocks. A stock with widely varying price fluctuations is, in effect, more volatile than one with smaller fluctuations.
Vol is expressed in percentage terms. This normalizes volatility so that the vol of two things can be compared in a straightforward way. A $10 stock that moves up and down $1 is experiencing 10% price changes, while a $1,000 stock that moves up and down $1 is experiencing price changes of 0.1%. Even though both stocks are moving $1, the $10 stock is more volatile. So no matter how complex vol might seem, it’s simply a metric that indicates the price changes of a stock or index.
For option traders, understanding vol is key. All things being equal, the theoretical value of an option will be higher if vol is higher and lower if vol is lower. This can help traders choose among strategies, such as credit spreads or short options if vol is higher, or debit spreads or long options if vol is lower. Further, options prices themselves can be turned into “implied volatility”(IV). That’s the vol after calculating an options pricing model that creates a theoretical value for an option equal to its market price. Vol can be backward-looking (historical vol) if it uses historical stock prices to calculate the standard deviations of returns. Vol can be forward-looking (IV) when options prices are used to estimate how much a stock might move up or down in the future. Let’s focus on forward-looking IV.
The Cboe Volatility Index (VIX) is one of the most popular and widely known measure of vol. It’s used as a metric for “the market’s” overall vol and does a pretty good job. But the VIX doesn’t exist in a vacuum. It’s calculated from S&P 500 Index (SPX) options prices.
Essentially, the VIX is a strike-weighted average of out-of-the-money SPX calls and puts.
As SPX options prices get pushed up and down, due to trading activity and market expectations of the magnitude of potential price changes in the SPX, they in turn move the VIX. The SPX options then beget the VIX. No SPX options, no VIX.
The VIX itself isn’t really a tradable product. Well, that’s not really true because you could theoretically buy or sell every single SPX option that goes into the VIX calculation and trade what’s called a “variance swap.” But that’s not likely a viable strategy for a self-directed trader, mainly because of the enormous commissions, execution costs, and large capital requirements. A more viable approach would be to trade vol products. For a breakdown, see “All Roads Lead to VIX.”
With the VIX at 13, a VIX 14 put with 90 days to expiration might be trading for 0.40. That looks far below its intrinsic value if you compare its 14-strike price to the VIX at 13. Why? The VIX options look at the /VX VIX futures prices to determine their value before expiration. A January VIX option, for example, is priced off the January/VX futures before expiration, not the VIX itself. As the /VX futures approaches expiration, its price and the VIX tend to converge. As the/VX price and VIX price get closer, a VIX option will still be priced off the /VX futures. But at expiration, when the /VX futures are settled to the settlement price of the VIX (VRO), whether a VIX option is in the money (and settles to its cash value) or OTM (and is worthless), its price is also determined by VRO. In this way, VIX options are priced off their corresponding /VX futures before expiration but settle to the VIX at expiration. And if the 90-day /VX futures is trading at 15, for example, that 14 put is considered OTM. VIX options, even though they’re cash-settled, look to the /VX futures that match their expiration for guidance on what vol might be in the future. So, prior to expiration, January VIX options are “priced” off the January /VX futures, March VIX options are “priced” off the March /VX futures, and so on.
Clearly the VIX is an important tool for gauging market sentiment. And it’s just the beginning. Savvy option traders know what goes into VIX, what comes out of it, and how to use it effectively to help determine their trading strategies. When innovations in vol products are introduced to self-directed investors, it’s critical to understand these foundational concepts so you can make sense of them. If you don’t, you could either miss a potential opportunity because the product is confusing, or you could take undue risks. Knowledge gives you control. And control is a good thing to have when trading something as potentially wild as volatility.
Before 2019, the VXX was an actively traded exchange-traded note (ETN)—a way for investors to speculate on the direction of vol. In January 2019, the VXX portfolio was liquidated, and the product delisted by its issuer, Barclays.
To replicate the performance of the market’s volatility (i.e., the Cboe VIX), VXX held a portfolio of long /VX futures. But when the /VX futures expired, the VXX would expire with them. To solve this, the VXX had to roll its position in a /VX futures in the near-term expiration to the /VX futures in the next expiration. It did this roll every day.
For example, on day one, the January /VX futures is the front month, and the VXX would be 100% in the January /VX futures. The next day, VXX would sell some of its January /VX and buy an equivalent amount of February /VX. This way, when the January /VX futures had expired, the VXX portfolio would be 100% in February /VX.
That daily roll is a problem, though. Very often, the second-month /VX futures is in contango to (higher than) the front-month /VX futures. Sometimes the /VX futures were in backwardation, with the front-month /VX trading over the next-month /VX.
Losses from the daily roll when /VX futures were in contango dragged on the VXX’s price. This price decline was never going to end, and when the VXX’s actual charter expired 10 years after its creation in 2009, Barclays closed it down.
But because the VXX had been popular, Barclays created a new ETN, VXXB, to replace it. VXXB matures in 30 years instead of VXX’s 10 years. VXXB is also “callable” by Barclays. However, its portfolio is still composed of /VX futures and is still impacted by the rolls. Also, Barclays renamed VXXB to VXX in May 2019. So in effect, VXX is back, as well as its options.
Enter VXX into the Charts tab of the thinkorswim® platform from TD Ameritrade to see its historical chart. You’ll find its options on the Trade tab. Just make sure you understand the details of the /VX roll in the VXX before you trade it.
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