VIX Options, Explained

 |  Includes: TVIX, VXX, VXZ
by: Angad Guglani

The VIX (CBOE Volatility Index) is a measure of the implied volatility in SP 500 options contracts, and investors are now able to trade this index by buying options on this index. One can only buy options on this index because there is no underlying security to purchase, as the VIX is just an index based on calculations. Keep in mind that these options are cash settled, and are European style in that you are not able to exercise them until the day of expiry.

Since the VIX options are European style, pricing of these options is not based on the Black-Scholes method of pricing, but rather based on what will likely happen. For example if the VIX is at what investors believe to be an abnormally high level, the price of calls (bullish bets) will be quite cheap, while the price of puts (bearish bets) will be expensive. This is so because investors are betting the index will fall by the time the options are set to expire.

The above would not work with American style options because for example, if the VIX was at 40 and strike 35 calls were selling at $2, someone could just buy the calls and exercise them upon purchase for a $3 profit. In the case of European style options like the VIX, this is not possible, as you can only exercise options at the date of expiry - at which point, the VIX will likely be lower than the price it was at when you purchased the options.

VIX options are a great tool to hedge your portfolio from systemic risk, but trading actively on the VIX itself is very risky. Trading the VIX is so risky that an ETF tracking 2X (TVIX) the movement of the VIX fell over 60% last week. Additionally every bet made on the VIX is zero sum, meaning that no actual wealth is created - it is just re-distributed.

For investors who are not familiar with derivatives, there are always other ways to trade the VIX index including ETFs such as iPath S&P 500 VIX Short-Term Futures (VXX), VelocityShares Daily 2x VIX Short Term (NASDAQ:TVIX), and iPath S&P 500 VIX Mid-Term Futures (VXZ).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.