Using the VIX

09/22/2008 12:00 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

When I talk to traders about the VIX and how to use it to understand what is going on with investor sentiment, they will often get very interested in trading the channel it tends to stay within. I also think that is a good idea, since channels can be very profitable for traders. However, although there are calls and puts available for traders on the VIX, they are unique compared to most calls and puts that stock option traders are used to. In order to make this series about implied volatility as practical as possible, I think a discussion about how to trade options on the VIX will be useful.

1. The VIX options are not based on the index, they are based on the VIX futures. If you are not a futures trader, this subject may seem complicated, but it really isn't that hard to understand. What you need to know is that the VIX is also traded as a futures contract and there is one of these futures contracts available for each of the next few future months. This means that the current month's VIX futures contract looks very similar to the VIX index, but the futures contract that expires next month may look a little different because it will show what investors think about the market in the next month. Traders may be very fearful of current market conditions right now, but they may not be as fearful about where the market will be in a month or two months. That means that the VIX futures contract that expires this month will have a higher (more fearful) reading than next month's VIX futures contract, or the month after that, and so on.

2. Each month's option chain sheet corresponds to the same month's VIX futures contract. Imagine that today's reading on the VIX index is 30 and the VIX futures contract that expires this month is priced at about the same level. That is normal and therefore the at-the-money strike price will be 30. The calls and puts at the 30 strike price should cost a similar amount per contract as you would expect. However, if next month's VIX futures contract is currently priced at 25, because traders are less fearful about the market next month, then the at-the-money strike price for next month's options will be 25, not 30. In the video, I will show you how this works and why it can lead to a serious mistake by new traders. Most of the time, your broker's online trading station will not make this obvious and it can lead to traders drawing incorrect conclusions about the VIX options from one month to the next.

3. VIX options have an unusual expiration date. Equity traders are used to stock options and index options expiring on or just before the third Friday of the month. VIX options are different and have a very unusual expiration date. Fortunately, you can get an expiration calendar to assist your planning from the CBOE. VIX options expire on the Wednesday that is at least 30 days before the third Friday of the month following the expiration month. Got that? Here is how that works. Imagine that you are holding September 2008 VIX calls. The expiration month for those options is September, so we need to find the third Friday of the next month, which is actually October 17th. Counting backwards from October 17th to find the first Wednesday that is at least 30 days prior to October 17th gives us an expiration date of Wednesday, September 17th. We can make the same calculation to determine that October's options will expire on Wednesday, October 22nd. If that seems complicated, just get yourself an expiration calendar and don't worry about trying to work out the math. VIX options can be an important part of a well diversified trading strategy. Institutional traders use VIX options to hedge risk and to profit from market uncertainty and fear. The price channel can be easy to identify for a technician, and fundamental traders can use them to offset risk as growth begins to slow.

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