The Chicago Board Options Exchange Volatility Index, called the VIX, is a measure of implied volatility of options on stocks in the S&P 500 index. Also referred to as the fear index, it tracks market expectations of stock prices over rolling 30-day periods. Investors become increasingly nervous as volatility increases and display greater concern about market prospects as more options show heightened volatility. This behavior affects stock prices and presents an additional opportunity for profit for investment traders. The CBOE introduced the VIX in 1993.
VIX as a Trading Tool
Investors can use market volatility, as indicated by the VIX, to determine opportune moments to trade. They can also use the VIX to take a position on market volatility and create a more diverse portfolio. However, it is not possible to trade the VIX directly. Individuals wishing to benefit from market volatility can trade VIX futures and VIX options, the derivatives of the VIX.
On March 26, 2004, the CBOE introduced VIX futures (VX) as the first means of trading market volatility. These are similar to a standard futures contract and are based on a forward 30-day implied volatility of the S&P index. VIX futures allow investors to trade volatility without concern for stock prices. These futures also are an ideal tool for diversify portfolios, speculating and hedging returns on equity.
The price of VIX futures is sometimes on par with the VIX. At those times, a low VIX results in a low VIX futures price, while a high VIX results in a premium price. However, this is not always the case, so investors watch for variance and react accordingly.
VIX options (VIX) were first available for volatility trading on February 24, 2006. Similar to VIX futures, investors can trade VIX options without concern for market factors that affect stock prices, interest rates and time to expiration. VIX options have call options and put options. The call options allow investors to buy at a fixed price, while the put options allow the holder to sell at a fixed price. Both options must be completed within a given period of time.
The VIX moves in an opposite direction from the S&P index. Traders can avoid losses and make gains by carefully watching this movement. For instance, individuals who purchase VIX put options as insurance when market volatility drops can guard against the subsequent drop in stock price. Conversely, traders who purchase VIX call options when market volatility rises can reap the benefits of an increase in stock prices.
Trading VIX Derivatives
Individuals can purchase options or futures through investment service websites or through a professional broker. Investors can purchase VIX options with an account approved for options trade. There are no position or exercise limits, according to the CBOE.
VIX futures and options expire one Wednesday every month, 30 days before the third Friday of the following month. Investors can trade options up to the Tuesday before they expire and must exercise them on the expiration day. VIX options settle in cash on the day after expiration. The investor’s account shows a deposit or debit based on the results of the trade. The amount debited or credited is the difference between the purchase price and the settlement price multiplied by $100 for VIX options or $1,000 for VIX futures.