The VIX is an index, but not a typical one. Indices usually reflect the value of dozens or hundreds of different investments. Conversely, the volatility index (VIX) measures the volatility of market prices. Plainly stated, the VIX is not concerned with the current prices of securities. It focuses on how fast those market values are changing. The faster market values change, the higher the VIX.
Although volatility can occur in a bull or bear market, volatility is correlated with bear markets. Investors’ actions can turn into a vicious cycle in a significant market decline. When initial signs of a bear market begin materializing (e.g., corporate profits declining rapidly), some investors liquidate (sell) their portfolios and move to cash to avoid losing money on their investments. Because of the influx of sales, market values begin to decline faster. The market deterioration results in more investors liquidating their portfolios, bringing the market further downward. The cycle continues the more the market declines.
With volatility associated with market declines, the VIX is often called the “fear gauge.” The more investors worry about losing money, the more their trades increase market volatility.
VIX option test questions tend to focus on understanding 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 volatility. Therefore, an investor bullish on the market does not expect much volatility. With low levels of volatility expected, the investor expects the VIX to fall. Therefore, they should invest in bearish VIX options. Short calls and long puts are bearish options that will profit when the VIX falls.
You may encounter questions about interpreting 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. For the most part, you should approach a VIX option the same way you would any option. With that being said, can you answer the question above?
Answer = $300
The premium ($3) is the cost of an option contract. To find the overall cost, multiply $3 by the option multiple (100).
Let’s continue exploring 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 their overall profit.
The VIX can theoretically rise an unlimited amount, similar to stock prices. The further the VIX rises above 50, the more the short call loses.
The contract is “in the money” by $4 if the VIX rises to 54. When the investor is assigned (exercised), they must deliver the intrinsic value (“in the money” amount) in cash to the holder. In this case, the writer must deliver $400 ($4 x 100) to the holder, which completely offsets the $400 premium received upfront.
At 40, the contract is “out of the money” and expires worthless. Therefore, the investor keeps the $400 premium as their overall profit.
The contract is “in the money” by $10 at 60. The investor must deliver the intrinsic value (“in the money” amount) in cash to the holder when assigned. In this case, the writer must deliver $1,000 ($10 x 100) to the holder. The $1,000 loss due to the option assignment is offset by the $400 premium received upfront, bringing the overall loss to $600.
Let’s discuss when VIX options expire, which 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. That’s a mouthful! Additionally, VIX options typically maintain European-style exercise structures.
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