The Trader's Cure For the Volatility Blues

Potential strategies for a depressed VIX—When volatility is low, learn how to hedge a trader's version of "yield" by trading volatility as an asset class. futures options
10 min read
Photo by Max Broden

Stocks, bonds, cash. These are what investors consider traditional "asset classes." More adventurous ones might toss in commodities like precious metals, crude oil, or grains. And here's one more that might surprise you: volatility.

OK. “Vol” as an asset class might sound a little esoteric, and a little hard to fit into a portfolio. But if we define an asset class as a group of products that exhibit similar market behaviors, that’s in effect what volatility is. And we have the VIX, the CBOE’s volatility index. And VIX futures. And VIX options. It’s VIX options and futures that exhibit similar market behavior. 

When market temperament depresses VIX, you may find fewer equity trading opportunities. Or you might be concerned that a market drop could spike vol. Keep reading. You’ll soon understand how to treat volatility as an asset class, and find potential strategies for a low VIX. Once it’s all more familiar, you may discover potential opportunities more often—when the VIX is high, low, or in between. 

In order to understand other volatility products, let’s review the VIX itself. 

The Vix Index 

The VIX is an index (think Dow Jones Industrial Average, or S&P 500) that’s a weighted average of out-of-the-money (OTM) SPX options. It measures the overall implied volatility of SPX options. 

Remember that implied vol is derived from the market prices of options. And when plugged into an option pricing model, it’s the vol that makes the option’s theoretical value equal to the option’s market value. In a word, the VIX is a single implied volatility number that represents all SPX options. Let’s see how it works. 

The VIX is calculated from live SPX option price data. So, when you see a VIX at 15, for example, it’s based on a snapshot of the option prices. What happens if traders start buying OTM calls or puts? Option prices are set by the market’s buying and selling activity. So, with more demand (buying), the price goes up. And because OTM option prices are made up entirely of extrinsic value (the value of time to expiration and volatility), as their price goes up and time to expiration stays the same, their implied volatility goes up, too. 

As SPX option prices rise, that translates into a higher VIX. The traders might be buying the SPX options as a hedge against a big move in the market, or as a speculative trade. It doesn’t matter. The buying pressure on the SPX options increases their price. That, in turn, increases the VIX. The VIX is sometimes called the “fear gauge” because it goes up when traders think there might be a big up-or-down change in an index. 

Conversely, if traders think the market might not make any large moves, they sell their hedges, or sell options short. That selling pressure pushes SPX prices lower, which in turn pushes the VIX lower. This is how the VIX works as a handy snapshot of the market’s expectation of the potential magnitude of SPX price changes. 

But you can’t trade the VIX index itself. It’s just a number. That’s where the VIX futures come in.

Vix Futures

You can see quotes and charts for VIX futures on the thinkorswim® by TD Ameritrade platform using the symbol /VX. VIX futures are cash-settled, meaning they deliver cash into your account equal to $1,000 times the /VX settlement price at expiration. You can even see the settlement price on the platform with the symbol VRO. Basically, the /VX future, and VIX index converge at expiration. Before expiration, though, /VX futures move up and down as traders speculate on whether vol might be higher or lower by a future’s expiration. 

Keep in mind there’s no cost of carry for /VX futures because there is no underlying product like stocks, bonds, or commodities. So, the difference you see between the VIX index, and the /VX future is pure speculation on the market’s future volatility. When you see the different expirations of /VX futures, the basis between them is the market’s anticipation of where vol will be. For example, if you see the June /VX trading at 17, and the September /VX trading at 18, that’s the market’s way of telling you it anticipates higher vol by the time September rolls around. If the June /VX is trading at 20, and the September /VX is trading at 19, the market anticipates lower vol. 

Near-term/VX futures tend to be more volatile than further-term /VX futures. And that usually means bigger, faster moves to the upside. The mechanics of the VIX and /VX can help explain why. 

When the market starts to sell off quickly, traders and investors panic. The first thing they do is bid for OTM SPX puts, as either protection or as speculation on a crash. That spikes the VIX index. The near-term /VX futures rally in anticipation the VIX might stay higher, and that the price of the front-month /VX future will converge to a higher VIX price. Further-term /VX futures will rally, too. But not as much if the market believes it’s less likely the VIX will stay at a higher price by those further / VX expirations. This explains why /VX futures can go into backwardation, with the price of the front month /VX higher than the back-month /VX. 

And don’t be fooled by the relatively low prices of /VX futures. The contract size of the /VX futures is $1,000. So if you buy a /VX future for 16, and it drops to 15, you’ll be down $1,000. The minimum tick size of /VX is 0.05, which represents $50. 

VIX Options

VIX options are interesting. They’re European- style, and cash-settled, meaning any in-the-money (ITM) options deliver cash equivalent to $100 times intrinsic value at expiration. They settle to the same symbol— VRO—to which the /VX futures settle. To see VIX options, type in VIX on the Trade page of the thinkorswim® platform by TD Ameritrade. 

But here’s the tricky part. VIX options are priced off the /VX futures, not the VIX index. (See Figure 1, below.)

options on vix


The most common mistake trading VIX is confusing the options on VIX with the VIX itself. The options are actually based on /VX, or VIX futures (#1 above), which differs in price from the VIX (#2 above). Source: TD Ameritrade’s thinkorswim platform. For illustrative purposes only.

One concept in option pricing is that the options are priced off their hedge. For example, if you are short an XYZ call, you could hedge with long XYZ stock. That’s because the options deliver shares in XYZ, and you can trade XYZ stock. So, you calculate the theoretical value of XYZ options with the price of XYZ. 

At the closing bell, /VX basis trading isn’t for the faint of heart. If you’re already a proficient futures trader, consider this another tool in the strategy toolbox. But even if you’re not ready to trade it, /VX basis can certainly offer you clues as to how the market is forecasting volatility. 

But you can’t trade the VIX index. So, what’s the hedge to a VIX option? The closest thing is the /VX future. When a trader has a short VIX call, he can hedge with long /VX futures, even though both the VIX call and /VX futures settle to cash. The key is that both VIX options and /VX futures settle the same symbol (VRO) on the same expiration date. Because the VIX and /VX converge at expiration, the /VX future can act as a hedge to VIX options, and be the underlying to calculate the “theo” value of VIX options.

When you look at VIX options prices, they may not always make sense. For example, with the VIX at 16, the 17 put with 60 days to expiration is only 0.20, and the 17 call is 1.20. The OTM 17 call is trading for more than the ITM 17 put because the 17 call only looks OTM, and that call and put aren’t priced o the VIX at 16. Rather, they’re priced o the /VX future that expires 60 days out and is priced at 18.

When considering VIX options, you’ll also need to look at the /VX future that matches the options’ expiration. If you’re looking at June VIX options, you need to look at the June /VX future, because those VIX options are priced o the June /VX future. The price of the /VX future will tell you which calls and puts are ITM and OTM. 

Now that you’re more familiar with the VIX, /VX futures and VIX options, let’s see how you can use them as a volatility asset class. If you think that vol is low at a given point, and think it might go higher, consider three strategies of varying risk and potential profit. 

VIX Trading Strategies

STRATEGY 1: Buy /VX Future
This is the most aggressive strategy if you think vol will rise. It has the most risk and profit potential. And you need to choose the future expiration that matches your speculation.

Generally, the shorter term /VX future will rise and fall more than the further-term future. For example, if the S&P 500 crashes, the June /VX may rise 3 points, the September /VX may rise 2 points, and the December /VX may rise 1 point.

If you think volatility might rise sharply in the short-term, buying a near-term future might be the one to pick. If you do, compare its price to the price of the VIX. Remember, the two will converge at expiration. If the price of the near-term /VX is higher than the VIX, and if vol doesn’t rise in time, the price of the /VX could drift downward toward the VIX. Longer-term /VX futures have less problems with convergence, but typically rally less should the market crash. Balancing price sensitivity and expiration is the key to trading /VX futures. (Just keep in mind that short-term trading strategies can incur high commission charges.)

STRATEGY 2: Buy VIX Call Vertical
Pricing VIX options can be complex. But a long VIX call vertical spread still has risk limited to the debit you pay for it. And it’s still a risk that the VIX could go higher. The same decision you have about which expirations to buy for a /VX future also applies to buying a VIX call vertical. In addition, you need to choose long and short strikes.

Take a look at the price of the /VX. That determines the at-the-money (ATM) strike in the VIX options. Buying a call one strike ITM and selling a call one strike OTM based on the price of the /VX creates a bullish strategy with less risk, but also lower profit potential than a long /VX future. This creates a more conservative strategy.

STRATEGY 3: Long/VX, Short VIX Covered Call
Covered calls on volatility is the same type of strategy as covered calls on stock, but with important differences. When you sell an OTM call against long stock, you can collect income and reduce the effective cost basis of the long shares by the premium of the short, in exchange for limited profit potential. This can also work with a long /VX future and short VIX calls. Unlike covered calls in stock, quantity and expiration are more critical.

First, the value of the /VX future changes $1,000 for every point. And VIX options change $100 for every point. Because the /VX changes 10x more than the VIX option, you would sell 10 VIX calls against a single /VX future to create a covered call. If the VIX settles above the strike price of the short VIX call, the loss on 10 of those calls would equal the profit on the long /VX future between the strike price and the settlement price.

Second, you must match the expirations of the /VX future and the VIX options. Remember, the VIX options are priced o the /VX future that expires at the same time. If you don’t sell the VIX calls in the same expiration in which you’re buying the /VX future, you’re taking the risk of the /VX basis moving against you. For example, if you’re long the September /VX future, and short 10 June VIX calls, and the market crashes, it’s possible for the June /VX to rise more than the September /VX. Because your short VIX calls are in June, they’re rallying along with the June /VX. But your long September /VX isn’t keeping up. Your short June VIX calls can lose more than your long September VX is profi ting. Keep the expirations the same to avoid the additional risk of changes in the /VX futures basis.

These are three ideas of among many if things are just mulling along and you think volatility might rise. As long as you understand volatility products and specific risks, you can employ many of the same strategies you’d use for index or equity options to speculate on vol going higher, lower, or staying the same.


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