postTaking the VIX Apart

While the S&P500 has rarely experienced an ordinate move of more than 5% in the last 20 years, the VIX is a device to represent volatility expectations. Expressed as the expected price movement within one standard deviation this encompasses the likely probability of all contingencies but for 32% i.e. within a 68% probability. When combined with the VIX’s performance against the underlying S&P500, the VIX proves to be a perfect options trading strategy hedge in respect of the latter.

For over 20 years the VIX has moved in the opposite direction to the S&P500 88% of the time. When the underlying equity market has suffered a retracement of 3% the VIX has typically risen by 17%. These facts indicate the integrity with which the VIX is able to provide a hedge against the S&P500 equity market.

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In purchasing VIX out-of the-money calls or call spreads, or even selling put spreads in the VIX, a hedge of close proximity is to be had. Conversely, selling volatility by purchasing a put or put spread or selling calls or call spreads will achieve similar results. With the historical precedent set by the VIX against the S&P500, an investor can trade these hedges with confidence.

In visiting the mechanics of options types in the VIX, it is immediately noticeable that VIX options appear to mirror the ramifications of their underlying equity market options. Primarily this is due to the VIX option being a reflection of volatility direction not index or equity direction. This leads to a further discovery that the VIX by its very nature has certain limitations on its underlying value. Reflective of the anticipated price movement over the ensuing 30 day period the VIX is unlikely to dwindle at any time to a value of zero. Indeed, historically it indicates that 10% is a veritable floor. At the other end of the spectrum, the VIX has had occasion to visit levels above 45% but as could reasonably be expected, this type of indication lends itself to fantastic and sustained movement in the S&P500 for a 30 day period. Alas a ceiling for the VIX has presented itself over time.

This being the case, the VIX is a volatility indicator but shows that it also has a volatility of its own. Traditionally the VIX volatility has traded considerably higher than underlying S&P500 volatility. Annualized VIX volatility can reach 80% compared to the volatility range of equity and index markets of 10%-25%. Another point of relevance is that VIX volatility that is incorporated into its options is by nature based on volatility of the forward VIX contract which while still much higher than comparative equity and index markets, is always lower than the spot VIX contract. Froward VIX options volatility meanders at approximately 50%.  The VIX give traders a unique opportunity to trade options on a market that has well defined floors and ceilings, is not able to erode in value to zero and is imbued with considerable volatility.

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