O ver the past 18 months many esoteric financial prod-ucts have stepped into thelimelight — mortgage-

backed securities, collateralized debt obli-gations — but no tradable product hasgone from such obscurity to such promi-nence as options on the CBOE VolatilityIndex (VIX), in which average daily volume has increased 191 percent

since November 2008. Often referred to as the “fear” index,

the VIX measures the expected volatilityin the S&P 500 index (SPX) over thenext 30 days (see “The VIX”). Essentially,the VIX tracks what investors are willingto pay to hedge their equity portfolioswith S&P 500 options. Unlike most dis-cussions that focus on the VIX’s supposedpredictive power, the following discus-

sion examines cheap and creative waysyou can use options on the VIX index tooffset losses in a stock portfolio.

However, there are several potentialpitfalls to trading VIX options withoutexperience, including two potentiallycostly misconceptions.

Mistaken assumptionsFirst, the VIX doesn’t have any predictive

TRADING STRATEGIES

BY JEREMY WIEN

The VIX reality checkThere are many ways to hedge with VIX options,

but there are also many traps you can fall into if you

don’t know how these contracts work.

ACTIVE TRADER • May 2010 • www.activetradermag.com 1

FIGURE 1: S&P 500 & THE VIX, 2006-2009

The S&P 500 tends to move in opposite directions as volatility rises as stocks fall and vice versa. However, the VIX fellsharply in late 2008 as stocks continued to slide, a sign that no concrete relationship holds.

Source: eSignal

© 2010, reprinted with permission from Active Trader magazine.

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2 www.activetradermag.com • May 2010 • ACTIVE TRADER

Trading Strategies

power regarding the direction of thestock market. Each day various articlesand blog posts tout supposed VIX-stockmarket relationships — e.g., “The VIXand the SPX have risen in tandem for twoconsecutive days; nine out of the last 13times that happened, the SPX was downthe following day by an average of 1.3percent.”

At best, the VIX is a confirming orcoincident indicator, but even that con-nection is tenuous. Look no further thanthe financial meltdown from late 2008 toearly 2009 when the equity markets con-tinued to plunge while the VIX droppeddramatically. Don’t be fooled into trying

to time your equity trades based on VIXmovements.

More importantly, although optionssettlement is based on the cash (spot)VIX value, VIX options are priced usingthe VIX futures (VX). If you buy aFebruary 35 call option, your potentialgain at expiration is the greater of zeroand the VIX’s expiration value minus 35,while your potential loss is limited to theamount paid for the option.

However, mark-to-market pricing is adifferent story because VIX option valuesare based on the February VIX futures.The futures can trade near the cash VIXvalue, as they did in early 2008 when the

spot index and all the futures contractmonths traded consistently in the low tomid-20s. But sometimes the differencebetween the futures and the spot VIX canbe quite large, as it was during the creditcrisis, when the spot VIX was near 75and the second-month futures were trad-ing in the 60s. Intuitively, this makessense, as one would expect the VIX to belower two months forward than at thatmoment. If not, then someone couldhave bought a six-month 40-strike putfor pennies — far too cheap.

The relationship reverses when thespot VIX is historically low, as it was in2006. The spot VIX hovered around 10,but the six-month futures traded quite abit higher, because one would expect theVIX to revert toward its historical meanover time.

Like all options on futures, VIXoptions are valued based on the underly-ing futures rather than the spot-marketprice, but they cannot be exercised intoVIX futures positions — the options arecash-settled. That detail is often over-looked because the spot VIX value is soprominently reported in the financialmedia.

The VIX as portfolio hedgeHistorical volatility is the underlying mar-ket’s actual fluctuation over a definedperiod — say, the past 30 days. Impliedvolatility (IV) is the market’s estimatedfuture volatility and is reflected in optionspremiums — the higher the expectedvolatility, the higher the premium.

The relationship between IV and theVIX can be roughly calculated as follows:VIX divided by 16 should equal the S&P500’s expected daily percentage change.For example, if the VIX is at 24, theoptions market is pricing in an expecteddaily move of roughly 1.5 percent. Thedirection of the move is irrelevant,although given that volatility normallyincreases when the market is falling, as itdid in the fall of 2008, the VIX does tendto rise as the market falls and vice versa(Figure 1).

Because of the highly negative correla-tion between the VIX and the S&P 500

FIGURE 2: LONG VIX CALL

Buying a VIX call offers a high degree of protection against a stock-market crash.

FIGURE 3: VIX BULL CALL SPREAD

To reduce hedging costs, you could enter a bullish vertical spread on the VIX.The position will protect an equity portfolio, but not as completely as buyinga call outright.

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and other global stock indices, investorsprimarily use VIX futures and options togain upside exposure to the VIX as ahedge against a stock market downturn.

One of the most common ways tohedge and gain upside exposure to theVIX is to buy call options. When the VIXclosed at 21.50 on Dec. 4, 2009, youcould have bought a January 40 call for0.40. The position offers unlimited upsideexposure to the VIX while risking onlythe 0.40 premium and provides a highlevel of protection against a severe stock-market downturn. Figure 2 shows thelong 40 call’s potential gains and losses atexpiration.

A cheaper but less rewarding way tohedge is to enter a VIX bull call spread bypurchasing a January 37.5 call and sellinga January 47.5 call for a total cost (andrisk) of 0.35. Again, the goal is to gainupside exposure to the VIX, but in thiscase it’s accomplished less expensivelythan buying calls outright. The spread’spotential profit is the difference betweenits two strike prices (10) minus its premi-um (0.35), or 9.65.

The spread’s level of protection is mod-erately high. Figure 3 shows the bull callspread’s potential gains and losses atoptions expiration.

An even cheaper hedge combines a

credit bull put spread (short put, longlower-strike put) with a long call wellabove the put strike prices. On Dec. 4,you could have sold a January 22.5 putwhile purchasing a January 20 put and aJanuary 35 call for a total cost of 0.05.

This trade gains upside exposure to theVIX while paying virtually nothing for it.Figure 4 shows the risk profile for thisposition at expiration. Risk is limited tothe premium plus the difference in thestrike prices of the put spread (0.05 cost+ 2.5 strike-price difference = 2.55). Theposition’s potential gains are unlimited ifthe VIX surges, offering a high degree ofequity portfolio protection. However, thisposition adds some downside risk as away of lowering the hedge’s cost.

When market participants panicked inSeptember 2008, the VIX climbed muchhigher and faster than anyone had previ-ously thought possible. Low-premiumtrades that provide upside VIX exposurecan literally save a job, a portfolio, oreven an entire fund.

For example, a Société Générale cus-tomer in early September 2008 bought15,000 November 50 VIX call options for0.15 each. As the market continued tocollapse, the premium rose to more than$20, so at one point the $225,000 invest-ment was worth more than $30,000,000

(15,000 contracts * $20 premium * $100multiplier).

The most interesting trade of 2009The trades discussed so far are fairly“vanilla” in that they have a single pur-pose and a fairly straightforward direc-tional view. The most interesting tradefrom 2009, and one that has been copieda few times since a multi-strategy fundoriginally entered it around Labor Day, is

FIGURE 4: BULL PUT SPREAD + LONG CALL

This VIX options position combines a 22.5-20 bull put spread with a 35-strikecall. The purpose is to gain upside exposure to the VIX while paying virtuallynothing for it.

The VIXThe Volatility Index (VIX) measuresthe implied volatility of S&P 500index options traded on theChicago Board Option Exchange(CBOE). The VIX is designed toreflect the market expectation ofnear-term (in this case, 30-day)volatility and is a commonly refer-enced gauge of the stock market’s“fear level.” The original VIX,launched in 1990, was derivedfrom eight near-term at-the-moneyS&P 100 (OEX) options (calls andputs) using the Black-Scholesoptions pricing model.

The VIX underwent a majortransformation in late 2003. Thecurrent index is derived from bothat-the-money and out-of-the-money S&P 500 (SPX) calls andputs to make the index better rep-resent the full range of volatility. Atthe same time, the CBOE appliedthe new calculation method to theCBOE NDX Volatility Index (VXN),which reflects the volatility of theNasdaq 100 index. Other VIXindices have followed, includingones for the Dow Jones IndustrialAverage, Russell 2000, crude oil,gold, and the Euro.

The exchange still publishes theoriginal VIX calculation, which canbe found under the ticker symbolVXO. For more information about the VIX and its calculation, visit www.cboe.com/vix.

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much more complex. The trade is to sell a strangle (short an

out-of-the-money call and short an out-of-the-money put in same month) whilealso buying higher-strike calls at a ratio of1:3 or 1:4. For example, you would sellone January 25 put and one January 26call while buying three January 35 calls.This trade would allow you to collect apremium of roughly 2.20.

Figure 5 shows the position’s potentialgains and losses at the Jan. 20 expiration.The purpose of this trade is twofold:First, you are betting the VIX will trade ina fairly narrow range between Dec. 4,2009 and Jan. 20, 2010. However, if theVIX breaks out to the upside during asteep market correction, past a certainpoint (in this case the 35 strike), you arelong three VIX calls, which are in themoney (ITM) and offer more leveragethan just one contract.

Figure 5 shows there is a risk of losingmoney if the VIX grinds slowly higherinto the upper 20s or low 30s — but theVIX doesn’t usually grind higher.Historically, when the VIX moves higher,it does so rather quickly. If this patternrepeats, you would make money as theVIX approached and exceeded 40. Butthis trade also leaves some downside riskin the VIX.

The VIX traded in a fairly narrow rangefrom late July through early December2009, and this trade allowed traders totake advantage of that continued trajecto-ry while simultaneously being protectedin a crash. Given those seemingly contra-dictory goals, and that the strategy mademoney in the second half of 2009, it isthe most interesting VIX trade of the year.

Cover your tailLiquidity in VIX options has increasedsubstantially during the past 18 months.Not only has average daily volume nearlydoubled since November 2008, but thesize of a given trade that can be pricedreasonably without disrupting the marketalso has grown. Early in 2008, a 5,000-contract trade was considered large. Now,trades of 50,000 or even 100,000 con-tracts are more common. These largetrades attract more players (banks, hedgefunds, etc.) to the market. More players

will undoubtedly mean tighter markets,which will allow you to trade positionscheaper than before.

A common refrain these days is thatWall Street has a short memory. Perhaps,but it will take quite a while for anyone— on or off Wall Street — to forget thefall of 2008. Lawyers supposedly spend90 percent of their time preparing forevents that happen only 10 percent of

the time, and only 10 percent of theirtime preparing for events that occur90 percent of the time.

This attitude, which should have beenmore prevalent on the Street before 2008,is certainly omnipresent today. It will continue to drive demand to protectagainst so-called “tails” — extreme,unlikely scenarios that cause the mostproblems.Ý

FIGURE 5: VIX STRANGLE WITH BULLISH LEG

By combining a 25-26 strangle with three 35-strike calls, this trade will profit ifthe VIX trades in a fairly narrow range, but it also will gain ground if the stock market tanks.

Related reading ““The VIX and the financial crisis,,”” Active Trader, March 2010.The relationship between the CBOE Volatility Index and the stock market isn’tas clear as it appears at first glance.

““The VIX and market capitulations,,”” Active Trader, May 2009.It takes more than a VIX spike to identify a market bottom.

““The VIX fix,,”” Active Trader, December 2007.A synthetic VIX calculation can be used in any market to reproduce the performance of the well-known volatility index.

““Tracking VIX swings,,”” Active Trader, January 2006.The VIX has been a widely discussed stock market barometer, but how reliablydoes it identify market turning points? This study turned up a few surprises inanalyzing how the S&P 500 tracking stock (SPY) responded to VIX highs andlows.

““Trading System Lab: VIX-based system,,”” Active Trader, January 2006.This test uses a system described by Larry Connors in the TradingMarkets.comblog. The system tries to find oversold situations in the S&P by identifying VIXspikes.

Trading Strategies

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