A New Way of Trading Volatility
The CBOE Volatility Index (VIX) measures market expectations of near-term
volatility. This is achieved by estimating expected volatility from S&P 500
stock index options in a wide range of strike prices.
The VIX was launched in 1993 and has long been considered the benchmark for
measuring market volatility. Over the years, the VIX has undergone some changes
but the concept remains the same. It is a real-time view of expected stock
market volatility over the next 30-days.
It is often referred to as the “fear index†as market volatility usually
rises during times of financial stress, as witnessed recently when credit-market
turmoil spread to the stock market. Option prices, and the VIX, tend to rise
when the stock market declines. As the stock market stabilizes, option prices,
and the VIX decline. This action represents the level of fear investors feel,
which tends to rise and fall with the stock market.
As mentioned earlier, the VIX has undergone some changes. The most notable
one took place in 2003, and was implemented in 2004.* The VIX methodology was
changed, resulting in three important differences:
- The New VIX is calculated using a wide range of strike prices in order to
incorporate information from the volatility skew. The original VIX used only
at-the-money options. - The New VIX uses a newly developed formula to derive expected volatility
directly from the prices of a weighted strip of options. The original VIX
extracted implied volatility from an option-pricing model. - The New VIX uses options on the S&P 500 Index, which is the primary U.S.
stock market benchmark. The original VIX was based on S&P 100 Index (OEX)
option prices.
The chart below is the complete closing price history for the VIX, using the
new methodology. The chart shows that Friday, August 3, was the highest closing
price since the changes were made.
Trading the VIX
On March 26, 2004, the CBOE Futures Exchange (CFE) launched VIX Index
futures. Then, on February 24, 2006, the CBOE launched VIX Index options.
Options on VIX will have a multiplier of $100, and will have contract months
of two near-term contract months plus one additional month on the February
quarterly cycle. Trading hours will be 8:30 a.m. to 3:15 p.m. (Chicago Time).
The options will be European-style exercise, and will be cash settled.*
VIX Index options have gone on to become very popular, recently setting a new
daily volume record.
Longtime TradingMarkets members and readers will know that we have been using
VIX trading strategies for many years. In fact, Larry Connors was among the
first traders to publish research on the VIX. This research led to the creation
of a number of CVR signals (Connors VIX Reversal), many of which we still use
today. TradingMarkets members can access daily CVR signals in the
Market Bias section of the stock indicators. This section of the
TradingMarkets site is the ideal place to start planning for the upcoming
trading day. If you don’t have a TradingMarkets subscription,
click here to start your 7-day free trial.
This experience gives us, and our customers, a tremendous advantage in
building successful VIX trading strategies. We have been trading many of these
strategies with real money for more than a decade. The creation of VIX options
allows us to expand these strategies and tailor them specifically to focus on
trading the VIX itself.
Over the coming weeks we will be publishing a number of new VIX trading
strategies. These strategies have never been seen before and have some of the
best performance statistics we’ve ever published. We’re very excited about this
research and look forward to sharing it with you.
TradingMarkets members can access a number of articles previously published
articles by Larry Connors on the VIX in the
Learning Center.
Sign-up now for a no obligation, 7-day Free Trial to receive unrestricted
access.
*This information comes directly from the
CBOE website.