When the VIX is not really the VIX… Before trading VIX options, know that options you're trading aren't likely for the chart you're seeing.
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 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.
You can easily decipher the current value of the VIX futures by looking at the option chain in thinkorswim®. Just find the strike where the call value is roughly the same as the put value. That’s where the combo is at or closest to zero.
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.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Futures trading is not suitable for all investors as the risk of loss in trading futures is substantial. Futures trading privileges are subject to TD Ameritrade review and approval. Not all account owners will qualify. Futures accounts are not protected by the Securities Investor Protection Corporation (SIPC). Equity
options trading involves risks and is not suitable for all investors. Spreads and other multiple-leg options strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. Futures and futures options trading is speculative and is not suitable for all investors. Please read the Risk Disclosure for Futures and Options prior to trading futures products.
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.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. 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.
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. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.