With all the new ways to trade volatility, here is a primer on the VIX products:
CBOE OEX Implied Volatility Index (VXO)
I’m starting with the CBOE OEX Implied Volatility Index (CBOE:VXO) rather than the more well-known VIX, because it’s the grandfather of all things indexed volatility.
VXO is the original VIX. Robert E. Whaley invented this pup in 1993, with data calculated back to 1986. It seeks to proxy the implied volatility of a hypothetical at-the-money (ATM) option with 30 days duration. It uses a few series of near-money OEX options to calculate the number. At the time, OEX was the busiest index product. Until 2003, what you see on the board now as VXO was actually called the “VIX.”
CBOE Volatility Index (VIX)
The CBOE Volatility Index (CBOE:VIX) is essentially the “New Coke” to VXO’s “Original Formula.”
Here’s the quick description of the two big changes to the VIX methodology, straight from the CBOE’s mouth in 2003:
1. Based on S&P 500 Options Prices
“The new VIX will be based on prices of S&P 500 (SPX) options … Previously, the original-formula VIX was based on prices of the S&P 100 Index Options (CBOE:OEX), and CBOE will continue to calculate and disseminate the original-formula index to be known as the CBOE S&P 100 Volatility Index with the ticker VXO.”
2. New Formula for Calculation of VIX
“The new formula that will take into account a broader range of strike prices (rather than using only near-the-money strikes as the original-formula index did). Each strike price will be weighted, with at-the-money strikes having the most weight. The new formula is intended to make VIX a better index for investors who manage risks associated with the growing markets for volatility and variance swaps.”
Essentially, VIX incorporates all sorts of out-of-the-money (OTM) puts not included in VXO, so the ratio between the two yields clues to OTM put demand and skew.
Always remember that the VIX itself is a STATISTIC. No one buys and sells the actual VIX at actual prices. It doesn’t print. It opens when SPX options open and a value for VIX is first calculated.
CBOE Nasdaq 100 Voltility (VXN)
The CBOE Nasdaq 100 Voltility (CBOE:VXN) is the VIX Nasdaq style. Just substitute the Nasdaq for SPX above.
There was a time when the Nasdaq moved much more than SPX. That’s not the case any more, so this VIX product won’t add much to your trading toolbox.
CBOE S&P 500 3-Month Volatility Index (VXV)
The CBOE S&P 500 3-Month Volatility Index (CBOE:VXV) is the “new” formula VIX, but for an option with perpetual 90 days duration. The longer the duration of an option, the “stickier” implied volatility is. As such, VXV does not see the swings of the shorter-dated VIX. In fact, 90 days is a nice look at market assumptions about “mean” volatility.
VXV is a bit interesting now in that it has matched the lift in the VIX, indicating the market now considers current volatility levels somewhat normal.
VIX futures were listed in 2006. They confound and confuse investors in that they often do not move with the VIX itself. Again, it’s that pesky mean reversion. A VIX future is an over/under bet on where the VIX will “settle” on the opening of the day the future expires. They settle based on the opening quote in each applicable SPX option series, so the settlement price can deviate from the range of the actual VIX that day.
VIX futures expire 30 days prior to the next month SPX “regular” expiration, so VIX-piration is always a Wednesday, either two days before or three trading days after a regular SPX expiration.
VIX Monthly Options
These options are based off the corresponding VIX futures. They are European-style exercise, and expire (cash settle) on Wednesdays. Since VIX futures often trade at discounts to “cash” VIX, a VIX option can trade at what looks like less than parity to the actual VIX.
If you want to trade VIX options, get comfortable with all that, and the fact that you need to price the volatility of a volatility index.
VIX Weeklys are the newest VIX trading products. These weekly options on VIX futures expire on Fridays, as is the case with other weekly options, not on Wednesdays like standard monthly VIX options.
As I said before, monthly VIX options get cashed out when they expire, so you get delivery of nothing; you simply get a cash debit or credit based on the VIX settlement price and the options you are long or short. But with VIX Weeklys, you get delivery of a VIX future. So if you buy VIX weekly calls and they close in the money, you get delivery of VIX futures. And if you hold those VIX futures until expiration, you then cash settle based on the VIX settlement price at the future expiration.
iPath S&P 500 VIX Short-Term Futures ETN (VXX)
Finally, an actual VIX you can trade! Sort of. Listed in late January 2009, the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX) is an exchange-traded note (ETN) that proxies a perpetual 30-day VIX future.
In order to replicate that future, it must roll out nearer month futures or swaps each day. If the cycle it rolls into trades higher than the one it rolls out of (contango), VXX loses money in the process. VXX spends most of it’s time in contango.
According to some work by MKM Partners, VXX captures about 42% of the VIX move on up days, and 52% on down days, but keep in mind the relatively small sample size to work with here. In a non-contango backdrop, those numbers may vary.
See: How Closely Does VXX Track the VIX?
iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)
The iPath S&P 500 VIX Mid-Term Futures ETN (NYSE:VXZ) is like the VXX, but with four- to seven-month options. The curve out there is generally flat, so no contango problems.
Futures that far out also don’t move much, so you’re really not going to gain or lose much of anything by trading VXZ. It’s also pointless to hold it as it won’t actually move enough to hedge a portfolio in any important way.
VXX and VXZ Options
As complex and flawed as these proxies are, I would much sooner trade options here than on VIX futures. They are regular American-style exercise options, with delivery of the actual VXX or VXZ ETN.
OK, got all that? You won’t be tested, but let’s review:
* If you want a look at the here and now of implied volatility, use the VIX.
* If you want a view of “mean” assumptions, use VXV.
* If you want to actually hedge a portfolio, I’d always recommend making life easier and using actual SPX or SPDR S&P 500 (NYSE:SPY) options.
* But if you want to just trade volatility, I believe VXX and VXX options are the best proxy out there.
Follow Adam Warner on Twitter @agwarner.