Good Reasons to Trade the VIX

06/22/2010 12:01 am EST

Focus: OPTIONS

If you trade stocks, you may have heard the financial media talk about something called the VIX, also commonly referred to as the “fear index.” VIX stands for market volatility index, and it represents how investors perceive volatility in the marketplace. The VIX tends to peak during times the stock market is falling or expected to fall sharply, and the VIX is typically at low levels during more stable or bullish markets, when investors aren’t too worried. When investors are worried, they will clamor to purchase options for protection, and options premium rises. You can trade futures on the VIX to speculate on potential movement in the S&P 500, or as a hedge for your equity portfolio during times of heightened volatility.

If you trade options, you probably know about the Black Scholes model of options pricing, which includes an estimate of volatility. The model’s limitation is that it must use an estimate for volatility in calculating the theoretical option premium, and that estimate may or may not bear out. The Chicago Board Options Exchange (CBOE), where most options in the US are traded, developed a model to solve for the expected volatility using options prices in the S&P 100 and S&P 500.

The formula for VIX is very different from the Black-Scholes implied volatility familiar to option traders. VIX is based on a weighted sum of option prices, while in the Black-Scholes model, implied volatility is backed out of an option price. Traders would use historical volatility to estimate future volatility, but we know the market is constantly changing and what happened in the past may not happen the same way in the future.

The CBOE Volatility Index is based on real-time prices of options on the S&P 500 Index listed at the CBOE, and is designed to reflect investors’ consensus view of the future (30-day) expected stock market volatility. The market has more information than any one individual, and tends to be a more effective way to measure volatility. VIX uses near-term and next-term out-of-the money SPX options with at least eight days left to expiration, and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index. VIX futures are traded on the CBOE Futures Exchange (CFE).

The futures contract size is 1,000 times the index. So if the VIX is trading at 20, the notional value of a futures contract is $20,000. If the index went to zero (although theoretically impossible), you’d lose $20,000 if you were long the VIX futures from $20. Regular trading hours are similar to other stock index products, from 8:30 am - 3:30 pm CT. View full contract specs here.

VIX futures gain or lose value based on the price of the volatility index. Futures offer a useful tool to hedge a portfolio against market volatility. During the financial crisis in 2008 we saw a huge spike in volatility, reflected in the price of the VIX, which rose above 80. During the later part of 2009, the stock market grinded higher and we reached a low-volatility level. At that time, the VIX was trading in the teens and low 20s.

The noise about the sovereign debt crisis in Europe this spring created another spike in volatility, and the “flash crash” in the first week of May brought the VIX back up toward 50. You can see how the VIX levels correspond with peaks and valleys of the S&P 500 in the chart below. The VIX is in red, and you can follow its price on the left side of the chart. The S&P 500 is in black, with its price levels on the right. You can see how these two tend to be inversely correlated during times of sharp price movement, so trading futures on the VIX can offer investors a valuable hedge.

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Chart: Volatility Index vs. S&P 500 Index


Click to Enlarge

So Why Trade the VIX?

There are many signs right now that volatility will remain high in the market. If we do experience a sovereign debt crisis, it is difficult to protect yourself if you are a buy-and-hold investor. Stocks as well as most commodities tend to drop together in times of market panic because investors flee all assets they perceive to be risky.

The VIX futures can help insulate investors against this type of scenario. If you maintain a long position in the VIX, at times when the stock market grinds higher, the VIX will trade in a normal, low volatility range. But during unsettling times when options premium spikes, the VIX will move up dramatically and your long futures position can help offset losses you might have in stocks or other areas of your portfolio.

You might be thinking that you can just short S&P 500 futures instead. That approach might be fine if you basically just want to neutralize your portfolio during a bear market. You would gain on your futures position while the stock market drops, and lose money on your futures position when the stock market rises.

In contrast, the VIX only moves dramatically when there is a perception of risk in the marketplace. It offers a fairly strong inverse correlation when the stock market declines sharply. However, when the stock market grinds higher, the VIX typically trades in a tight range. It does not always trade inversely to the stock market in that case. The VIX can also climb even if the S&P doesn’t drop. Any time options premiums increase, due to perceived risk, you can profit from that scenario if you are long VIX futures. We do typically see option premiums spike when the stock market declines rapidly, but the point is it’s not always a one-to-one direct correlation.

This is a just a brief introduction to the VIX and how you might find trading VIX futures beneficial. There are many strategies you can pursue, and I encourage you to learn more.

By Aaron Fennell of Lind-Waldock

Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.

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