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.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Carefully consider the investment objectives, risks, charges, and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an exchange-traded product. Read carefully before investing.
ETNs are not funds and are not registered investment companies. ETNs are not secured debt and most do not provide principal protection. ETNs involve credit risk. The repayment of the principal, any interest, and the payment of any returns at maturity or upon redemption depend on the issuer’s ability to pay. The market value of an ETN may be impacted if the issuer’s credit rating is downgraded. ETNs may be subject to specific sector or industry risks.
Leveraged and inverse ETNs are subject to substantial volatility risk and other unique risks that should be understood before investing. ETNs containing components traded in foreign currencies are subject to foreign exchange risk. ETNs may have call features that allow the issuer to call the ETN. A call right by an issuer may adversely affect the value of the notes.ETFs can entail risks similar to direct stock ownership, including market, sector, or industry risks. Some ETFs may involve international risk, currency risk, commodity risk, leverage risk, credit risk, and interest rate risk. Trading prices may not reflect the net asset value of the underlying securities. Commission fees typically apply.
Leveraged and inverse ETFs entail unique risks, including but not limited to: use of leverage; aggressive and complex investment techniques; and use of derivatives. Leveraged ETFs seek to deliver multiples of the performance of a benchmark. Inverse ETFs seek to deliver the opposite of the performance of a benchmark. Both seek results over periods as short as a single day. Results of both strategies can be affected substantially by compounding. Returns over longer periods will likely differ in amount and even direction from the target return for the same period. These products require active monitoring and management, as frequently as daily. They are not suitable for all investors.
Examples presented are provided for illustrative and educational use only and are not a recommendation or solicitation to purchase or sell any specific security.
Futures and futures options trading involves substantial risk and is not suitable for all investors. Please read the Risk Disclosure Statement prior to trading futures products.
Futures accounts are not protected by the Securities Investor Protection Corporation (SIPC).
Futures and futures options trading services provided by Charles Schwab Futures and Forex LLC. Trading privileges subject to review and approval. Not all clients will qualify. Prior to a name change in September 2021, Charles Schwab Futures and Forex LLC was known as TD Ameritrade Futures & Forex LLC.
Charles Schwab Futures and Forex LLC, a CFTC-registered Futures Commission Merchant and NFA Forex Dealer Member. Charles Schwab Futures and Forex LLC is a subsidiary of The Charles Schwab Corporation.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2021 Charles Schwab & Co. Inc. All rights reserved.