VIX & VIX Market Basics

by joeyrb

Here’s a TLDR for those who don’t want to sit through the video.

What is VIX and how is it calculated?

Simply put, VIX uses 23-37 day SPX options to get an annualized, implied 1 standard deviation move (68%) in SPX. For example, if VIX is 15, then VIX is implying a 68% chance SPX is within + or – 15% over the next year. It is calculated by using the mid IVs of 23-37 DTE SPX options with non-zero bids. Thus, it is heavily influenced by what people are willing to pay for SPX options; specifically, when investors are fearful and they want protection, they buy SPX puts. As people increasingly bid up puts (since IV is the only variable in an option calculator with constant DTE and strike), VIX rises.

What does it mean?

VIX is a crowd sourced indicator we can use to see what SPX options prices are implying about moves in the future; however, it is not a predictor of what volatility will be in the future. Let’s say that markets are relatively efficient (EMH). Therefore, only new news will affect what people are willing to pay for SPX options. Humans (investors) are very bad at predicting the future which is why a central theme in behavioral finance relating to option pricing revolves around a premium to realized volatility. There are long term averages for realized volatility of SPX (and any security) which is why VIX is a mean reverting security. Markets can remain at these low levels for very long times and no one is capable of predicting how long this will last.

VIX Products

The main VIX product is VIX futures since you can not trade spot VIX. There are monthly futures (3rd Wednesday of each month) going out 7 months and weekly futures going out 6 weeks. All futures expire on Wednesday mornings using VRO, a special opening quotation based on SPX options that morning, and settled in cash. Typically (85% of the time), the VIX futures are in contango. This means the 1st month VIX future is priced above spot VIX and the 2nd month VIX future is typically above the 1st month future (see: vixcentral.com). Let’s think back to behavioral finance and mean reversion of VIX on why this might be. People always want some premium to where the long term mean is (there would be no motivation to sell volatility otherwise) so it makes since that if VIX is at 12 today, I want 14 to sell you volatility one month out. Remember, these futures are pricing what the market thinks VIX will be on that given 3rd Wednesday on the month. So if VIX hits 40 today, the future for the upcoming month might only move to 25 because VIX is a mean reverting security and market participants believe that volatility on that upcoming expiration will be lower than where spot VIX currently is.

VIX options (these are European and settle in cash) use their given future as the underlying – again, not spot VIX. So if I’m buying Dec VIX options, I’m buying options on the Dec future, not spot VIX. My spot price is the price of that Dec future is (again, 85% of the time this is much higher than where spot VIX is). I, therefore, need VIX to be above my strike price on the day that Dec future expires to be ITM. Of course, I can sell these options before expiry if the future is moving towards my strike.

Overall, it becomes very hard to get long vol and long SPX puts are the way to go unless you can get the timing exactly correct. However, with the way the futures markets are structured and the composition of VIX related ETPs (VXX, TVIX, SVXY) going short vol (and long mathematics because of the structure of these products) is a great trade when VIX markets become backwardated and in general. I can cover VXX and other products in another post if people are interested, but I thought it would be a good beginning to cover the basics of VIX and its markets first.

 

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.

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