Trading Options On VIX: For Dummies

by: Reel Ken

Writing articles on various option strategies requires a broad knowledge of how options work, and volatility is one of the main components. So I read just about every article that I can on "the VIX" to gather as much information as I can to better understand how this works.

With the exception of one recent article, I have avoided writing much about "the VIX." The reason is simple... there are so many authors on Seeking Alpha that have a much deeper knowledge than I do (Bill Luby, for example).

VIX options are "strange" when compared to stock options. They involve near and far term futures, unusual settlement prices, are cash settled, and experience contango and backwardation, just to name a few. This makes trading VIX options seem a strategy best left to the pros.

On the other hand, one does not have to know how to make a watch in order to tell time. With this in mind, I think there are some very interesting strategies that can be employed without having to dissect VIX options into tiny pieces. I am purposefully leaving out derivatives of VIX such as VXX,XXV, VIXY and others. So, for all you "watch-makers" I apologize, but for "time tellers," let's go on.

I can't encourage anyone to try and compete with the "pros" as a trading strategy, but there are certainly several strategies involving VIX options that can be employed to complement a portfolio.

First, one needs to recognize that though VIX generally goes down on a market rise and up on a market drop, it doesn't always follow that pattern. Notwithstanding this, and the fact that very few can predict in advance if the market, let alone VIX, is going up or down, one can plan a strategy based upon the assumption that VIX will move inversely to the market.

One method detailed in my previous article, linked above, involved selling near term naked PUTS when the VIX reached some level, specifically 15 or below. If the VIX rose, then you collected a little "insurance," and if VIX fell below the strike (15), simply roll forward. If VIX never exceeds 15, you may have lost a little (depending on premiums), but when VIX eventually exceeds 15 (practically a guarantee, given the environment), then you will have collected on your "insurance." I even recommend "doubling down" if VIX drops as low as 13.

VIX is now trading at 15.56, so whether this is as attractive now depends upon your desire for "insurance."

Rather than just selling naked PUTS on VIX, when VIX is somewhat higher and shows signs of contango, a calendar spread can be effective. The best way to notice this is if the premiums on PUTS are very close, even as the expiry increases. For instance, both the January 2013 and February 2013 16 strike PUT have a bid/ask of $1.05/$1.15. This equalization doesn't exist with normal options, but as I said, VIX options are "strange." When this occurs, I look to sell the January 16 strike PUT for a credit of $1.05, and buy the February 16 strike PUT for a debit of $1.15. Total cost is a debit of 10 cents.

So if VIX rises above 16, the January 16 strike premium of $1.05 is fully earned. If the February strike is worth more than 10 cents, profit ensues. Unless VIX goes way, way, way up, gain is a very likely outcome.

On the other hand, if VIX drops, you may also show profit. The January 16 strike would have to fall below 15 before the January short PUT shows loss. If it fell to, say 14, that option would lose about $1, but you have the February long PUT. Initially, it was worth $1.15, and you would expect it to be at least $2 on the VIX drop. With a normal option, you could expect the February option to increase in value, but because of VIX option "strangeness," this may not hold true. Most of the time the outcome is profit, but no guarantees.

But I don't mind, for even if there is a slight loss on a drop of the VIX to 14, it usually means the portfolio was unscathed and I'll now convert to naked PUTS for "insurance."

One might even consider the December 19th 16 strike PUT for a credit of 90 cents, against either the January or February $1.15 debit. A little more risk, but it is only a week till expiry and it has a high chance of success.

Summary: VIX options don't behave like normal options. Normally, I would advise against trying to "trade" them for profit. However, they can be integrated into "portfolio insurance" when the time is right. And the time may be very right.

Disclosure: I buy and sell options on VIX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.