One of the least understood but most rewarding futures contracts is VIX options. As international option traders, we have found that explaining this contract to traders is easier said than done.
Those familiar with US-style possibilities often find it difficult to understand how the contract works and why it exists at all.
What are VIX Options?
The “VIX” or simply “Vol” for short – has been around since 1993.
It began life as a way to measure investor sentiment in certain index products, specifically
- S&p 500 (the SPX),
- Dow Jones Industrials (the YM)
- Nasdaq100 (the NQ).
The VIX was initially calculated based on S&p 500 index options but later expanded to include other major US indices options.
The VIX measures volatility in a very peculiar way. Despite being called an “index”, the VIX is not an index of anything!
For example, you cannot find it quoted on any stock exchange. There are no equity components involved at all.
VIX Options Explained
First things first – two types of VIX contracts exist side-by-side: cash-settled and futures based. Both have different characteristics that suit other people.
Those familiar with US-style options often find it difficult to understand how the contract works and why it exists at all.
Strike Price vs Last Traded Price
The strike price is well-known in equity options trading but less in index options.
To put it simply, the strike price is the “piece” of the index value at which an option contract may be exercised for a payout.
For example, if you buy a call option with a strike price of 25 on the VIX, you are entitled to purchase the underlying security at 25 even if it is trading at a higher price on the open market.
Conversely, if you sell a put option with a strike price of 25, you are obliged to sell the underlying security at 25 even if it is trading at a lower price on the open market.
The critical point is that the strike price remains fixed regardless of how high or low the VIX index might trade.
In contrast, an index option’s last sold price (LTP) constantly changes as it follows the underlying security. This is one key reason why VIX options are not as popular as standard equity options.
The other reason has to do with the fact that VIX options are European-style options. This means they can only be exercised on the expiration date and not before.
The final reason has to do with the fact that VIX options are cash-settled contracts. This means no physical delivery of the underlying security upon exercise. Instead, the contract is closed out, and the price difference paid/received is settled in cash.
Why Trade VIX Options?
The main reason traders might want to trade VIX options is their unique exposure to implied volatility.
Unlike standard equity options, VIX options offer a pure-play on suggested volatility changes. It can help hedge or take advantage of volatility skew in the market.
Here are some reasons why traders might want to trade VIX options:
- Protection against a sharp move in the market.
- Hedging or neutralizing an existing position.
- Trading opportunities arise from implied volatility skew.
- Leveraging a view on the VIX.
How to Trade VIX Options
There are different ways that you can trade VIX options:
- Buy Calls for bullish sentiment.
- Sell Puts for bearish sentiment.
- Spreads (calendar or diagonal) for hedging or taking advantage of volatility skew.
- Butterflies and Condors for more complex strategies.
Conclusion
The CBOE Volatility Index, or “VIX”, is a unique index that measures investor sentiment in the stock market. Despite not being an index of anything, it has become one of the most widely followed indicators in financial markets.
The VIX is calculated using S&p 500 options and is a crucial barometer of market volatility.
Trading VIX options can be a profitable endeavour, but it is essential to understand the unique characteristics of these contracts before diving in.
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