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Taking Advantage of Recent Lows in the Volatility Index


How do options traders use the VIX?

One of the newest option products to appear in our universe as an options trader is the option series designed to trade the Volatility Index (^VIX). The VIX is a measurement of the implied volatility of the S&P 500 Index (INDEXSP:.INX).

To review quickly, the implied volatility of an options series is reflective of the aggregate market opinion of the future volatility of a given underlying asset. In terms of the Volatility Index, the price is the current market opinion of the future volatility in the S&P 500 Index over the next 12 months.

As are all attempts to predict the future, this value does not always reflect accurately the actual volatility as it plays out prospectively, but at a practical level, it is the best we can do. As sage philosophers have long noted, "The future isn't what it used to be."

The importance for traders is the well-established and generally known inverse correlation between prices for the given underlying asset and the measure of implied volatility, in this case our VIX value. What is typically less known is the fact that levels of implied volatility correlate even more closely to the velocity of the price move of the underlying asset in question.

Because rapid price moves occur far more frequently to the downside, it follows that the general correlation between price and implied volatility is inverse. A fundamental characteristic that underscores the logic of this trade is the strong tendency of the VIX to revert to its recent mean. While this is not a certainty, it is unquestionably a high probability outcome.

For professional traders, much of the focus of hedging activity has recently moved to establishing protective positions in this index rather than older techniques such as buying out-of-the-money protective index puts. However, there are some well-recognized pitfalls in this approach that lay in wait for the retail trader not aware of some of the nuances inherent to this approach.

One of the major risks in trading this product derives from the fact that the options are based on the value of VIX futures. Because there is no mandatory mathematical linking of the value of these futures in the several available expiration months as is routinely present in the options series with which most traders are familiar, a huge and not generally recognized risk exists.

The founders of one of the major retail options brokers have repeatedly cautioned that the single major cause of irreparable account "blow-ups" they witnessed were the result of time spreads, a.k.a., calendar spreads, in this VIX product. This is the result of the ability of the various expiration months to move without mutual correlation in response to significant market events.
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