OptionsHouse

Options Trading News

October 14, 2011  Fri 12:20 PM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
The VIX has gotten a lot of attention lately because of the market's wild swings. Along with that heightened awareness has come an onslaught of new products based on the volatility index and bad information about it.

First we have some new volatility funds rolling out. ProShares has introduced an UltraShort VIX Short Term Futures fund and a Short VIX Short Term Futures fund. They aren't really new except for the fact that they are exchange-traded funds as opposed to exchange-traded notes.

The big difference between the two is a lack of counter-party risk in ETFs that exists in ETNs. It will be interesting to see if anyone really cares about such things at this point (or understands enough to care). So far the volatility funds that have been around the longest have gotten the most volume.

The other new product is quite interesting but isn't available yet and may not be widely accesible to retail traders. The Chicago Board Options Exchange has created "variance strips" (VSTRP) to bundle strips of SPX options, allowing traders to more closely "trade" the VIX--which raises one of my pet peeves.

The VIX is a calculation based on strips of SPX options and, contrary to what many apparently believe, is not tradable unless you actually trade all of those SPX options. All current VIX based products are comprised of, or priced off of, the VIX futures, which are future projections of where the VIX will be. These variance strips will change that, but only for the most sophisticated traders.

This leads to one of the most common misconceptions about the CBOE Market Volatility Index and its relationship with the S&P 500. It is understood that there is a strong inverse relationship between the VIX and the SPX, but the nature of that relationship is often confused.

This following comment, attributed to UBS equity strategist Jonathon Golub, doesn't help. "Over the past three years, for every 5.5 percent change in the VIX, stocks moved 1 percent in the opposite direction. Applying this relationship, a fall in the VIX from 43 to 20 would correspond to a rise of roughly 10 percent in the S&P 500."

While this may be true, the observation strikes me as simplistic and misleading.

It is simplistic in that it treats the relationship between the SPX and VIX as mechanical and static, which it is not. From October of 2008 to March of 2009, for example, the VIX fell from 80 to 50 while the SPX fell from 1100 to 666. So while the VIX is very likely to come down from current levels, it doesn't necessarily mean that the SPX will rise. (The two-year chart below shows the VIX in blue and the SPX in purple.)

VIX

More troubling, Golub implies--even though he uses the word "corresponds"--that a drop in the VIX moves the SPX higher, which is simply not true. The VIX has to do with risk perception and the actual volatility in the market.

This is one of the most important issues in using volatility to hedge portfolios. There is no question that long volatility can be a great hedge against sharp declines in equities. But when volatility is high, it is very possible that volatility will fall even as equities do.

That point seems to be widely misunderstood by many players in the market--even professionals-- and it is the reason that index puts and put spreads are better hedges in these types of markets.

There is no question that outright puts are very expensive, but put sellers will tell you that the biggest problem they face is "path dependency": The actual volatility of the underlying may turn out to be less than the implied volatility of the option, but the seller can still lose (and the put buyer win) because the underlying stock can move lower on low volatility.

If you buy an "expensive" put with an implied volatility of 40 percent, you can still profit if the underlying moves lower 1 percent a day for 30 straight days. In that case, puts would lose value on volatility but gain on the directional move of the underlying. Straight volatility hedges, like VIX calls or volatility ETFs or ETNs would simply lose value.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Oct. 5. Chart courtesy of tradeMONSTER.)
Share this article with your friends


Related Stories

VIX

Videocast: Selling high VIX strikes

January 30, 2015

Group One's Jamie Tyrrell says today's big volatility trades are selling this pop in the VIX, unloading the February 29 and 30 calls.

VIX

VIX drops as equities bounce back

January 30, 2015

The major equity indexes rebounded yesterday after the steep selloff in the previous session, and the CBOE Volatility Index dropped nearly 19 percent.

VIX

Videocast: VIX action 'wishy washy'

January 29, 2015

After the VIX soared late yesterday, Group One's Jamie Tyrrell says today's volatility trading is "wishy washy" as the pits try to decide which way the market is heading.

VIX

Videocast: April call spread in VIX

January 28, 2015

Low volumes persist in volatility trading, but Group One's Jamie Tyrrell says one trader is buying a VIX April 18/25 call ratio spread.

VIX

VIX rises as equities fall on earnings

January 28, 2015

Equity indexes lost ground after a slew of disappointing earnings reports but did finish off the lows of the session. The CBOE Volatility Index gained nearly 11 percent.

Invest Like a Monster - Las Vegas: March 13-14

TRADING WEEKLY OPTIONS

The fastest money in the market
View full report »

Premium Services

Archived Webinar

Option Money Machine Winter Classic

Education & Strategy

The rolling technique

In the January 7th edition of Advantage Point, we initiated the purchase of a second week-out GOOGL 535 put at...

View more education articles »