What the Volatility Index Can Tell You About Investors

The Volatility Index or VIX is reaching higher every day as the stock market drops lower and lower. As I am writing this, the VIX spiked over 30 for the first time since March, 2008. The VIX is used to measure investors’ expectations of market volatility over the next 30 days. It is calculated from the implied volatilities of S&P 500 options, and is popularly known as the “Fear Gauge”. Simply stated, the higher the VIX the more fear there is in the market since more S&P 500 puts are being bought, by investors, as insurance against steep declines. It uses the nearby and second nearby options, weighing them to create a constant 30-day measure of expected volatility. VIX readings above 30 indicate extreme fear and uncertainty in the market, readings below 20 reflect a lackluster, confident market. The VIX is usually inversely correlated with the market itself. The lower and faster the market declines, the higher VIX readings go. Here are charts comparing the VIX with the S&P 500 so you can visualize the inverse correlation:

The VIX makes a great market analysis tool, however, what many traders do not realize, is the VIX itself can be traded via options and futures. This article will provide a brief overview of VIX options and explain how they can be used right now to profit from the recent volatility.

VIX options were introduced in 2006 by the CBOE. They use a multiplier of 100 and are listed in 2 1/2 point strike price intervals. The minimum tick size for VIX options trading below 3 is $5.00 and above 3 is $10.00. The symbol is VRO, and they expire on Wednesday not Friday as is the typical option expiration day. They are exercised European style, meaning only on the day of expiration. VIX options are different than normal index options when it comes to pricing. Index option pricing assume a log normal distribution since the underlying can theoretically go to zero, however VIX can not go to zero as that would assume no movement in the S&P 500 whatsoever. The VIX is normally “mean reverting” this is KEY for the VIX option trader. What this refers to is historic high VIX levels are more likely to drop to the average VIX levels, and low VIX levels are likely to rise. Price will revert back to the mean, in statistical terms. Pricing of VIX options can be very complex due to these differences from regular index or stock options. There is an excellent white paper on the CBOE site explaining pricing in detail, should you be interested in digging deeper in the pricing formulas used by the exchange.

It is also important to note that the volatility of volatility is extremely high. You can see from this chart (courtesy of the CBOE) of the volatility of several stocks and indexes pale in comparison to the volatility of the VIX:

Therefore when trading the VIX options you are trading volatility on volatility to a higher degree relative to other equity based options.

Given the mean reverting nature of the VIX, and the high current levels, its appears that a bearish longer term option position would make sense. One could short call credit spreads, go long put spreads, or simply buy puts, if they believe the VIX will revert back to the mean within the life time of the options.

David Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.