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.
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.
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.
Prices of traditional futures contracts are based on a “cost of carry” calculation, but prices of VIX futures contracts are determined in a different way. If soybeans are trading at $7.00 per bushel, for example, and if interest, storage, insurance and other carrying costs amount to 10 percent per year, then the fair value of a one-year soybean futures contract is $7.70. Market participants known as arbitrageurs will sell futures and buy soybeans in the cash market, and thereby keep the pricing relationship constant.
VIX futures contracts are different from traditional futures contracts, because there is no underlying cash commodity. As a result, there is no arbitrage-pricing relationship, and no role for arbitrageurs to play. This means that prices of VIX futures contracts will not necessarily move in tandem with the VIX index.
Prices of VIX futures contracts are based solely on expectations. Specifically, the price of a VIX futures contract represents the market’s expectation of what the 30-day implied volatility of SPX options will be on expiration day.
An analogy to VIX futures contracts might be a hypothetical futures contract on the temperature at a specific time at a specific location. Assume, for example, that today is July 1 and you are trading a futures contract on the temperature at noon in Anchorage, Alaska, on January 1. You might estimate that “it will be cold,” and maybe the futures will be trading at “-20,” indicating an expected temperature of 20 degrees below zero at noon on January 1 in Anchorage. The question is, if the temperature in Anchorage on July 2 rises to record lows, say 70 degrees above zero, how will this affect the price of the January 1 futures contract? The answer is “not very much, if at all.” Why not? Because the temperature on July 1 in Anchorage is most likely unrelated to the temperature in January.
The temperature in July could rise and fall back and forth between unprecedented levels. Such changes, however, would most likely not change the expectation for the temperature on January 1. Only as January 1 approaches will changes in temperature begin to affect futures prices. If it were 10 degrees above zero on December 25, for example, it is unlikely that the January 1 temperature futures would remain near -20. However, if the temperature changed on December 26 and 27, then the price of the January 1 futures contract could be expected to follow those changes more closely.
Graph 2 shows the closing levels of the VIX Index and the closing prices of the August ’07 VIX futures contract from Feb. 1, 2007, through expiration on Aug. 16, 2007. Similar to the hypothetical “temperature futures contract” described above, prices of the August ’07 VIX futures seem to be little affected by changes in the VIX Index from February through June. The futures price was relatively constant despite several-point rises and declines in the VIX index. Only in July did futures prices start to follow the VIX index.
The simple message of Graph 2 is that VIX futures are increasingly responsive to the VIX index as expiration approaches. It follows, therefore, that the near-term VIX futures contract should be traded if the forecast calls for an imminent rise or fall in the VIX index.
Unique Pricing Characteristics of VIX Options
VIX options have one major difference from most other options, and that is the “underlying instrument.” When pricing GE options, the “underlying price” is clearly the price of GE stock. Similarly, for options on November Soybean futures, the underlying price is the price of the November futures contract. For VIX options, however, the price of the relevant VIX futures contract should be used as the price of the underlying and not the VIX index.
This leads to some seemingly unusual price relationships. On March 5, 2007, for example, the VIX index closed at 19.63, the August ’07 VIX Futures closed at 14.53, and the August ’07 VIX 15-strike call closed at 1.95. To the casual observer, with the VIX index at 19.63, it might seem that a 15-strike call has intrinsic value of 4.63. It would, therefore, seem that the August 15 call was trading 2.68 below parity. However, when you see that the August 15 put closed at 2.40, it is clear that the August futures price of 14.53, the 15 call price of 1.95 and the 15 put price of 2.40 are almost perfectly in line with put-call parity. Remember, also, that VIX options are European-style, so early exercise is not possible. The conclusion is that VIX options are not necessarily “cheap” if they appear to be trading for less than intrinsic value compared to the VIX index.
VIX futures and options also have unique expiration dates. They both settle on a Wednesday that is 30 days before an SPX options expiration. Since there are four weeks between many SPX option expirations and five weeks between some, expiration of VIX futures and options can occur on the Wednesday before some SPX expirations (when there are four weeks to the next expiration) or on the Wednesday after (when there are five weeks between expirations). The last day of trading for VIX futures and options is a Tuesday, and then they settle on Wednesday morning to a special opening quotation of the VIX index.
The unique pricing characteristics of VIX futures and options leads to some unique thinking when it comes to picking a strategy that targets the goal of protecting a portfolio.
With regard to VIX futures, the conclusion from Graph 2 is that the front month VIX futures contract is the most responsive to changes in the VIX index. Therefore, if you expect a market decline in early October, the October VIX futures contract is the contract of choice. If your forecast calls for a market move in late October or early November, then the November contract is the one to trade. If your forecast calls for a market decline sometime in the next six months, then the six-month futures contract is not necessarily the contract to use, because that contract might not be the front contract when the market move occurs. The choice of a VIX futures or VIX option contract for hedging purposes is more difficult than is the selection of a traditional futures contract.
Unique Hedging Strategies
The purchase of puts to protect individual stocks and portfolios is a well-known strategy. When it comes to VIX puts, however, the thinking is reversed. Since the VIX index usually rises when the market declines, VIX puts can also be expected to decline. Therefore, selling VIX puts is arguably a portfolio-protection strategy. The risk of selling puts, however, should not be overlooked. If VIX futures are trading at a premium to the VIX index, then the futures price might decline to the index level at expiration. In such a scenario, VIX options might rise as the VIX futures converge with the VIX index.
VIX futures and options are the newest tools available to both investors and traders. Their unique pricing characteristics and product specifications, however, make them especially challenging. The trading history of VIX futures and options indicates that front-month contracts are likely to be the most responsive to changes in the VIX index. Option traders should also be aware that, prior to expiration, the VIX futures price should be used as the “price of the underlying” and not the VIX index itself. The challenges of selecting an expiration date and a strike price are no easier for VIX options than they are for stock and index options.
James Bittman is a senior instructor at The Options Institute at the Chicago Board Options Exchange.