The VIX is an index, but it isn’t a typical one. Most indices track the value of dozens or hundreds of investments. In contrast, the volatility index (VIX) measures how volatile market prices are.
In plain terms, 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:
Because volatility is often linked to market declines, the VIX is commonly called the “fear gauge.” The more investors worry about losing money, the more their trading 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 expects the market to rise and, typically, expects less volatility. With lower volatility expected, the investor expects the VIX to fall.
So, the investor should use bearish VIX positions. Short calls and long puts are bearish strategies that can profit if 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 other option.
With that in mind, can you answer the question above?
Answer = $300
The premium ($3) is the cost per contract unit. To find the total cost, multiply the premium 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. The investor keeps the $400 premium as the overall profit.
The VIX can theoretically rise without limit, similar to stock prices. The higher the VIX rises above 50, the larger the loss on the short call.
At a VIX level of 54, the option 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 × 100), which exactly offsets the $400 premium received.
At 40, the option is out of the money and expires worthless. The investor keeps the $400 premium.
At 60, the option is in the money by $10. If assigned, the investor must deliver $1,000 ($10 × 100) in cash to the holder. The $1,000 assignment loss is partially offset by the $400 premium received, resulting in a net loss of $600.
Let’s discuss when VIX options expire, since their expiration schedule differs from most options. Most options expire on the third Friday of the month. VIX options expire on the Wednesday that is 30 days before the third Friday of the following calendar month. Additionally, VIX options typically maintain European-style exercise structures.
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