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November 13, 2007

A Closer Look at Volatility

A New View for Trading VIX Options and Futures

By James Bittman

Also in this article

Volatility-specifically, perceived volatility-is an important factor in determining the price of options. An index that tracks changes in volatility was created by the Chicago Board Options Exchange in 1993. Since then, this index, formally known as the CBOE Volatility Index and commonly known as the VIX, has become a commonly cited

index that many market analysts use as a market forecasting tool. In March 2004, futures contracts began trading on the VIX index, and, in February 2006, options began trading.

This article will discuss the unique characteristics of VIX futures and options contracts, and why traders must think differently when trading them.

Background

Implied volatility is the volatility percentage that justifies the market price of an option. Option contracts are like insurance policies, and the volatility component in option prices corresponds to the risk factor in insurance premiums. In insurance, it is the expected risk or predicted risk that determines premiums. Risk premiums in insurance can differ from historic risk, because the expectation for future risk can differ from historic risk. Similarly, the volatility component in option prices-implied volatility-can differ from the historic volatility of the underlying stock, because the market can expect that future stock price action will differ from the past.

For options on market indexes, implied volatility can vary by strike price and expiration. It is sometimes difficult, therefore, to say whether implied volatility is rising or falling. The VIX was created to address this problem. Just as the S&P 500 Stock Index is a measure of changing stock prices, the VIX is also a measure of changing levels of implied volatility. Specifically, VIX is a measure of market expectations of near-term volatility conveyed by SPX option prices.

VIX and the Market

The SPX-VIX graph illustrates the well-known inverse relationship between the S&P 500 Stock Index and the VIX. The period is January through August 2007. During this period, there were two obvious instances-early March and mid-August-when a falling S&P 500 was accompanied by a rising VIX. During other periods, a rising S&P 500 index was accompanied by a level-to-declining VIX.

The inverse relationship between the S&P 500 and the VIX is explained by investor psychology. It is believed that "investors panic" when the market declines. Specifically, when the market shows signs of weakness, investors and traders rush to buy index puts, which creates an imbalance of demand over supply. The result is an increase in implied volatility, which is a rise in option prices relative to the market level.

The tendency of the VIX to fall as the market rises is believed to occur because there is a better balance between demand for and supply of options when the market is rising.

VIX Futures

The potential value of "trading the VIX" can be gleaned from Graph 1. When the S&P 500 declined from about 1550 to about 1410 from late July to mid-August, the VIX index rose from 12 to 30. During this period, a profit from a long position in VIX futures could have reduced a loss from a declining S&P 500 portfolio.