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3,867 posts
msg #82707
Ignore Kevin_in_GA
11/9/2009 4:10:14 PM

Measuring Investor Fear—the VIX®
by Randy Frederick, Director of Trading and Derivatives, Schwab Center for Financial Research
March 11, 2009

Often referred to as the “investor fear index,” the VIX is a measure of the market’s expectation of volatility over the next 30 days. The VIX can help you take a position on market volatility, typically with lower costs than those associated with multi-leg options strategies. The VIX also can be used to help establish a partial hedge against sharp market moves.

It’s a widely held belief that the market is driven by two things: fear and greed. If that’s true, then having a way to help gauge one of these emotions—fear—could be beneficial. The Chicago Board Options Exchange® (CBOE®) Volatility Index (VIX), often referred to as the investor fear index, is a popular measure of the market’s expectation of volatility over the next 30-day period. It is calculated using the implied volatility of S&P 500® Index options (SPX). A spike in the VIX often corresponds to a more volatile market because investors who see a high risk of a change in prices will usually be required to pay a greater premium.

In this article, we’ll look at how you may be able to use the VIX to take a position on volatility, and as a hedge against sharp market moves.

What makes the VIX different?

It’s important to realize just how different options on the VIX are from other options. Since the VIX is an index of implied volatility, a VIX option is an option on implied volatility—not on a stock, ETF or stock index. If you’ve ever traded options, you probably know that the price of an option is partially based on the implied volatility of the underlying instrument. In this case, that underlying instrument would be implied volatility. If that’s true, then the implied volatility of VIX options is the implied volatility of implied volatility, which would be the second derivative of the price of the SPX. Unless you are a brilliant mathematician, just thinking about this can give you a headache. Since spikes in volatility tend to be relatively larger than the market movements that cause them, the volatility of volatility is quite extreme. As a result, the implied volatility component used in the calculation price of VIX options may make them appear significantly more or less expensive than traditional options. Note: You can find quotes for the VIX by visiting and entering the symbol $VIX.

Volatility skyrockets

It might surprise you to learn that prior to the tremendous volatility spikes in October and November 2008, volatility as measured by the VIX had been at historically low levels for over five years (with the exception of a few very small spikes in August 2007, January 2008 and March 2008). In contrast, spikes like these in October and November are precisely why the actual (long-term historical) volatility of the VIX is quite high, especially over the past 10–15 years (the VIX was introduced in 1993). It’s interesting to note that from mid-2003 until mid-2008, any volatility spikes above 30% were considered to be high.

Recent volatility levels (which are relatively low compared to fall 2008) remain far above the 30% level. To give you an idea about how much more volatile the VIX is than the SPX, on January 16, 2009, the 20-day historical volatility of the VIX was 84.17%. To put this in perspective, on October 22, 2008, the 20-day historical volatility of the VIX was over 243%. This is considerably higher than the volatility you’ll find for all but the most volatile stocks in the marketplace.

Why has the VIX been so volatile?

As I mentioned before, the VIX is intended to measure the implied volatility of the SPX. Implied volatility is an annualized standard deviation. On October 22, 2008, the VIX was at 89.53 and the SPX was at 877.00. This level of the VIX implies that over the next 30 days, options prices on the SPX are indicating that there is a 68% chance (one standard deviation) that the range on the SPX will be between 651.90 and 1102.10 over the next 30 days. That is a forecasted potential increase or decrease of over 25% in 30 days (nearly 90% on an annualized basis). If you imagine the level of investor anxiety that would exist if the SPX dropped 25% in a month, I think you can see why the VIX is so much more volatile than the SPX. Now imagine the change in price of VIX options if the SPX dropped 25% and I think you can see why the implied volatility of VIX options has been so high.

How to use the VIX to take a position on volatility

Trading options on the VIX gives you the opportunity to trade one of the most—if not the most—volatile issues in the entire marketplace. This creates a number of potential opportunities that were unavailable prior to the creation of the VIX. You no longer have to establish expensive long straddles and strangles or short butterflies and condors to take a position on volatility. If you expect increasing market volatility (which has historically occurred during a sharp sell-off), you can use a long call option on the VIX to attempt to capitalize on your forecast. Similarly, you can replace negative volatility strategies like short straddles and strangles or long butterflies and condors with a long put option on the VIX. A long put on the VIX will likely gain value as overall market volatility decreases (which has historically occurred during a rally), and, since this is a single long put trade, it can typically be executed with less risk and lower transaction costs than multi-leg strategies.

How to use the VIX to establish a potential hedge

Another way to consider using VIX options is as an “insurance policy” or hedge against a sharp market move. In theory, implied volatility is non-directional; in practice, it has typically demonstrated far more sensitivity to downside moves than to upside moves. This means that instead of attempting to hedge a portfolio of stocks by buying an ETF or index put option, you may be able to do it more cheaply by buying a VIX call option. While no option strategy can provide a perfect hedge to your portfolio unless you own shares in the exact proportions of the benchmark index, historically the VIX has appeared to overreact to market downturns. As a result, VIX calls could rise in value much faster than a typical index put option, potentially allowing you to offset some or all of the losses in your stocks at a much lower cost.

How a VIX hedge might work

If you purchase a long put option, it will likely have a delta (ratio that compares the change in the price of the underlying asset to the change in the price of a derivative) of less than –1.00, unless it is deep in the money. This means that the put will gain value at a rate that is less than dollar for dollar with the drop in the index. For example, assume you had a portfolio that was closely correlated to the SPX. An SPX put option with a delta of –.70 will only gain .7% for every 1% lost in the SPX. However, because the VIX tends to react in an amount that exceeds the movement in the SPX, the VIX might increase 1.5% or more with a drop in the SPX of 1%. If you owned a call option on the VIX with a delta of .70, it might increase in value at a rate of 70% of the increase in the VIX. That would be .70 x 1.5% = 1.05%. This exceeds the 1% decrease in the SPX, which suggests your hedge might potentially exceed the loss incurred. Note: This is only an example and cannot be guaranteed. VIX options are closely tied to futures contracts on the VIX; as a result, their valuations can be affected by a number of factors. It is possible for VIX options to react in an amount that is greater or less than the move in the SPX.

Other measures of volatility

Watch any of the financial channels and you’ll always hear the experts carrying on about “volatile markets,” but how do you measure such an arbitrary thing? The VIX is not the only volatility gauge out there. Volatility on the Nasdaq can be measured with the CBOE Nasdaq Volatility Index (VXN), and volatility on the Russell 2000® can be measured using the CBOE Russell 2000 Volatility Index (RVX) both of these trade options, too.

Understand VIX options before trading them

Be careful when trading the VIX. Standard pricing models based on the old Black-Scholes formula—the first widely used options pricing formula—won’t work the same way for VIX options as they do for other options because VIX options are a second derivative. Consider that, at least in theory, any stock can go to zero or infinity. Without too much thought, it’s pretty obvious that volatility can’t go to infinity, and it also can’t go to zero. This means that the lognormal distribution curves that options pricing models are based on don’t really apply, because the upper and lower tails will be much fatter than those of an individual equity. Additionally, since volatility tends to revert to the mean, even when it spikes sharply higher, it isn’t likely to remain there for very long. As a result, you should always watch your position closely, as exit opportunities may be short-lived.

Potentially complicating matters further, the price of VIX options is based on the anticipated level of the VIX at expiration rather than the current level of the VIX. This means you’ll probably see a closer correlation of price to the VIX futures on the CBOE Futures Exchange (CFE®) than to the actual level of the VIX index. In other words, prices for VIX options expiring in the month of May will most closely reflect the level of the June futures contract, while prices for VIX options expiring in August will most closely reflect the level of the September futures contract. Don’t assume that VIX options reflect the current quote of the VIX. It may appear that options with later expiration dates are “cheaper” than options with earlier expiration dates, or that the options are trading at a discount to the intrinsic value, neither of which is likely true.

Even more confusing is that VIX options expire on the Wednesday that is 30 days prior to the third Friday of the calendar month immediately following the expiration month. This means that the expiration date could be either prior to or subsequent to the regular equity option expiration, depending on the month. To learn more about the nuances of VIX options, we encourage you to visit the CBOE website and read the VIX White Paper.

14 posts
msg #82787
Ignore cubtrader
11/10/2009 4:54:20 PM

That was a great article, thanks for posting it……..I think the Vix is the single most important thing to look at in the entire economy. I’ve got a big graph in front of me right now pasted to my wall. The Vix from 1990 to 2000. It looks to me like you might consider liquidating all your stock positions when the Vix pops up toward around 38-40.

353 posts
msg #82790
Ignore BarTune1
11/10/2009 6:00:51 PM


studies show that the VIX is a dynamic indicator and thus the best way to view it (for purposes of trading) is to analyze it relative to where it has been (i.e., its variance) ..... more specifically, vs. its 10 dma

they used to say buy at 20 and sell at 30, however, backtesting has shown that it is inefficient (or that you will lose money) by trying to time trades, or the overall market for that matter, based on a fixed VIX entry or exit.

14 posts
msg #82822
Ignore cubtrader
11/11/2009 8:35:27 AM

Bar….I agree completely, to me the VIX is like the distance from the beach for a swimmer. At 20ft no big deal….30ft ok now what….but 40ft or more can spell trouble. Now that everyone is looking at it, it might not be such a great indicator cause that how things work, but I just know from about ’91-’98 was great and mid ’03-’08 was not bad. Those were both soft areas for the Vix.

353 posts
msg #82838
Ignore BarTune1
11/11/2009 10:17:38 AM

Definately, and i'm in trouble today ..... lol

3,867 posts
msg #82840
Ignore Kevin_in_GA
11/11/2009 10:22:29 AM

Me too, buddy ... I plan on buying more later today, near the close, and average in over the next day or two as needed.

Luckily, my GNW stock has offset all of my short plays today. Only a fractional loss right now.

353 posts
msg #82845
Ignore BarTune1
11/11/2009 10:57:06 AM

i covered alot of my M short position the other day listing to the empty suits on CNBC ..... my paired trade with JCP would have made a killing today ...

I shorted WYNN at 66.60, BKS at 20.40 and bought SDS at 36.19 this morning ..... but my margin is extended ....

I need more patience.

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