The VIX is an index, but it isn’t a typical one. Most indices track the combined value of dozens or hundreds of investments. By contrast, the volatility index (VIX) measures how volatile market prices are.
In other words, the VIX isn’t focused on the current level of security prices. It focuses on how quickly market values are changing. The faster market values change, the higher the VIX.
Volatility can occur in both bull and bear markets, but it tends to be associated with bear markets. During a significant market decline, investor behavior can create a vicious cycle. When early signs of a bear market appear (e.g., corporate profits declining rapidly), some investors liquidate (sell) their portfolios and move to cash to avoid further losses. That wave of selling pushes market values down faster. As the decline accelerates, more investors sell, which drives prices down even more. The cycle can continue as long as selling pressure builds.
Because volatility is often linked to market declines, the VIX is commonly called the “fear gauge.” When investors worry about losing money, their trading activity can increase market volatility.
VIX option test questions often focus on market sentiment. For example:
If an investor is bullish on the market, which of the following VIX options should they invest in?
A) Long VIX calls and long VIX puts
B) Long VIX calls and short VIX puts
C) Short VIX calls and long VIX puts
D) Short VIX calls and short VIX puts
Answer = C) Short VIX calls and long VIX puts
Significant market declines are associated with higher volatility. A bullish investor doesn’t expect a major decline, so they don’t expect volatility to rise. With low volatility expected, the investor expects the VIX to fall.
That means they want bearish VIX positions. Short calls and long puts are bearish strategies that can profit when the VIX falls.
You may also see questions that ask you to interpret a VIX option quote. For example:
An investor goes long 1 VIX Jan 40 put at $3. What is the cost of the contract?
As we learned in the index option chapter, non-equity options are similar to equity options. In most cases, you’ll approach a VIX option the same way you would any option. With that in mind, you can answer the question above by using the standard option multiple.
Answer = $300
The premium ($3) is the cost per option contract unit. To find the total cost, multiply $3 by the option multiple (100).
Let’s keep building on the idea that non-equity options are very similar to equity options.
Short 1 VIX Jan 50 call @ $4
Using your fundamental options knowledge, find the following:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at 40
- Gain or loss at 60
Like a regular equity option, the premium is the maximum gain for a short call. If the VIX stays below 50, the option is out of the money and will expire worthless, allowing the investor to keep the $400 option premium as the overall profit.
The VIX can theoretically rise without limit, similar to stock prices. The further the VIX rises above 50, the more the short call loses.
At a VIX level of 54, the call is in the money by $4. If the investor is assigned (exercised), they must deliver the intrinsic value (the in-the-money amount) in cash to the holder. Here, that intrinsic value is $400 ($4 x 100), which exactly offsets the $400 premium received upfront.
At 40, the contract is out of the money and expires worthless. The investor keeps the $400 premium as the overall profit.
At 60, the contract is in the money by $10. If assigned, the investor must deliver $1,000 ($10 x 100) in intrinsic value to the holder. That $1,000 loss is partially offset by the $400 premium received upfront, resulting in a net loss of $600.
Let’s discuss when VIX options expire, because their expiration schedule differs from most options. Normally, options expire on the third Friday of the month. Instead, VIX options expire on the Wednesday that is 30 days before the third Friday of the following calendar month.
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