Trading VIX Derivatives

Trading and Hedging Strategies Using VIX Futures, Options, and Exchange-Traded Notes

Russell Rhoads

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470933084
• eBook ISBN: 9781118118481
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Finanzas

A guide to using the VIX to forecast and trade markets

Known as the fear index, the VIX provides a snapshot of expectations about future stock market volatility and generally moves inversely to the overall stock market. Trading VIX Derivatives will show you how to use the Chicago Board Options Exchange's S&P 500 volatility index to gauge fear and greed in the market, use market volatility to your advantage, and hedge stock portfolios. Engaging and informative, this book skillfully explains the mechanics and strategies associated with trading VIX options, futures, exchange traded notes, and options on exchange traded notes.

Many market participants look at the VIX to help understand market sentiment and predict turning points. With a slew of VIX index trading products now available, traders can use a variety of strategies to speculate outright on the direction of market volatility, but they can also utilize these products in conjunction with other instruments to create spread trades or hedge their overall risk.

• Reviews how to use the VIX to forecast market turning points, as well as reveals what it takes to implement trading strategies using VIX options, futures, and ETNs
• Accessible to active individual traders, but sufficiently sophisticated for professional traders
• Offers insights on how volatility-based strategies can be used to provide diversification and enhance returns

Written by Russell Rhoads, a top instructor at the CBOE's Options Institute, this book reflects on the wide range of uses associated with the VIX and will interest anyone looking for profitable new forecasting and trading techniques.

Chapter 1

Understanding Implied Volatility

In this book, we will discuss the ins and outs of a popular market indicator, or index, that is based on implied volatility. The indicator is the CBOE Volatility Index®, widely known by its ticker symbol, VIX. It should come as no surprise that a solid understanding of the index must begin with a solid understanding of what implied volatility is and how it works.

Implied volatility is ultimately determined by the price of option contracts. Since option prices are the result of market forces, or increased levels of buying or selling, implied volatility is determined by the market. An index based on implied volatility of option prices is displaying the market's estimation of volatility of the underlying security in the future.

More advanced option traders who feel they have a solid understanding of implied volatility may consider moving to Chapter 2. That chapter introduces the actual method for determining the VIX. However, as implied volatility is one of the more advanced option pricing concepts, a quick review before diving into the VIX and volatility-related trading vehicles would be worthwhile for most traders.

HISTORICAL VERSUS FORWARD-LOOKING VOLATILITY

There are two main types of volatility discussed relative to securities prices. The first is historical volatility, which may be calculated using recent trading activity for a stock or other security. The historical volatility of a stock is factual and known. Also, the historical volatility does not give any indication about the future movement of a stock. The forward-looking volatility is what is referred to as the implied volatility. This type of volatility results from the market price of options that trade on a stock.

The implied volatility component of option prices is the factor that can give all option traders, novice to expert, the most difficulty. This occurs because the implied volatility of an option may change while all other pricing factors impacting the price of an option remain unchanged. This change may occur as the order flow for options is biased more to buying or selling. A result of increased buying of options by market participants is higher implied volatility. Conversely, when there is net selling of options, the implied volatility indicated by option prices moves lower.

Basically, the nature of order flow dictates the direction of implied volatility. Again, more option buying increases the option price and the result is higher implied volatility. Going back to Economics 101, implied volatility reacts to the supply and demand of the marketplace. Buying pushes it higher, and selling pushes it lower.

The implied volatility of an option is also considered an indication of the risk associated with the underlying security. The risk may be thought of as how much movement may be expected from the underlying stock over the life of an option. This is not the potential direction of the stock price move, just the magnitude of the move. Generally, when thinking of risk, traders think of a stock losing value or the price moving lower. Using implied volatility as a risk measure results in an estimation of a price move in either direction. When the market anticipates that a stock may soon move dramatically, the price of option contracts, both puts and calls, will move higher.

A common example of a known event in the future that may dramatically influence the price of a stock is a company's quarterly earnings report. Four times a year a company will release information to the investing public in the form of its recent earnings results. This earnings release may also include statements regarding business prospects for the company. This information may have a dramatic impact on the share price. As this price move will also impact option prices, the option contracts usually react in advance. Due to the anticipation that will work into option prices, they are generally more expensive as traders and investors buy options before seeing the report.

This increased buying of options results in higher option prices. There are two ways to think about this: the higher price of the option contracts results in higher implied volatility, or because of higher implied volatility option prices are higher. After the earnings report, there is less risk of a big move in the underlying stock and the options become less expensive. This drop in price is due to lower implied volatility levels; implied volatility is now lower due to lower option prices.

A good non-option-oriented example of how implied volatility works may be summed up through this illustration. If you live in Florida, you are familiar with hurricane season. The path of hurricanes can be unpredictable, and at times homeowners have little time to prepare for a storm. Using homeowners insurance as a substitute for an option contract, consider the following situation.

You wake to find out that an evacuation is planned due to a potential hurricane. Before leaving the area, you check whether your homeowners insurance is current. You find you have allowed your coverage to lapse, and so you run down to your agent's office. As he boards up windows and prepares to evacuate inland, he informs you that you may renew, but the cost is going to be $50,000 instead of the $2,000 annual rate you have paid for years. After hearing your objections, he is steadfast. The higher price, he explains, is due to the higher risk associated with the coming storm.

You decide that $50,000 is too much to pay, and you return home to ride out the storm. Fortunately, the storm takes a left turn and misses your neighborhood altogether. Realizing that you have experienced a near miss, you run down to your agent's office with a $50,000 check in hand. Being an honest guy, he tells you the rate is back down to $2,000. Why is this?

The imminent risk level for replacing your home has decreased as there is no known threat bearing down on your property. As the immediate risk of loss or damage has decreased tremendously, so has the cost of protection against loss. When applying this to the option market, risk is actually risk of movement of the underlying security, either higher or lower. This risk is the magnitude of expected movement of the underlying security over the life of an option.

When market participants are expecting a big price move to the upside in the underlying security, there will be net buying of call options in anticipation of this move. As this buying occurs, the price of the call options will increase. This price rise in the options is associated with an increase risk of a large price move, and this increase in risk translates to higher implied volatility.

Also, if there is an expectation of a lower price move, the marketplace may see an increase in put buying. With higher demand for put contracts, the price of puts may increase resulting in higher implied volatility for those options. Finally, if put prices increase, the result is corresponding call prices rising due to a concept known as put-call parity, which will be discussed in the next section.

PUT-CALL PARITY

Put and call prices are linked to each other through the price of the underlying stock through put-call parity. This link exists because combining a stock and put position can result in the same payoff as a position in a call option with the same strike price as the put. If this relationship gets out of line or not in parity, an arbitrage opportunity exits. When one of these opportunities arises, there are trading firms that will quickly buy and sell the securities to attempt to take advantage of this mispricing. This market activity will push the put and call prices back in line with each other.

Put and call prices should remain within a certain price range of each other or arbitragers will enter the market, which results in the prices coming back into parity. Parity between the two also results in a similar implied volatility output resulting from using these prices in a model to determine the implied volatility of the market.

Stated differently, increased demand for a call option will raise the price of that call. As the price of the call moves higher, the corresponding put price should also rise, or the result will be an arbitrage trade that will push the options into line. As the pricing of the option contracts are tied to each other, they will share similar implied volatility levels also.

For a quick and very simple example of how put-call parity works, consider the options and stock in Table 1.1.

Table 1.1 Put, Call, and Stock Pricing to Illustrate Put-Call Parity

Stock/Option	Price
XYZ Stock	$50.00
XYZ 50 Call	$1.00
XYZ 50 Put	$2.00

Using the XYZ 50 Put combined with XYZ stock, a payout that replicates being long the XYZ 50 Call may be created. The combination of owning stock and owning a put has the same payout structure as a long call option position. With the XYZ 50 Call trading at 1.00 and the XYZ 50 Put priced at 2.00, there may be a mispricing scenario. Table 1.2 compares a long XYZ 50 Call trade with a combined position of long XYZ stock and long a XYZ 50 Put.

Table 1.2 Payout Compari...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Preface
• Acknowledgments
• Chapter 1: Understanding Implied Volatility
• Chapter 2: About the VIX Index
• Chapter 3: VIX Futures
• Chapter 4: VIX Options
• Chapter 5: Weekly Options on CBOE Volatility Index Futures
• Chapter 6: Volatility-Related Exchange-Traded Notes
• Chapter 7: Alternate Equity Volatility and Strategy Indexes
• Chapter 8: Volatility Indexes on Alternative Assets
• Chapter 9: The VIX as a Stock Market Indicator
• Chapter 10: Hedging with VIX Derivatives
• Chapter 11: Speculating with VIX Derivatives
• Chapter 12: Calendar Spreads with VIX Futures
• Chapter 13: Calendar Spreads with VIX Options
• Chapter 14: Calendar Spreads with VIX Options and Futures
• Chapter 15: Vertical Spreads with VIX Options
• Chapter 16: Iron Condors and Butterflies with VIX Options
• About the Author
• Index