Trading the VIX to Hedge Stock Market Volatility

Trading the VIX to Hedge Stock Market Volatility

by Aaron Fennell

If you trade stocks, you may have heard the financial media talk about something called the VIX, also commonly referred to as the “fear index.” VIX stands for Market Volatility Index, and it represents how investors perceive volatility in the marketplace. The VIX tends to peak during times the stock market is falling or expected to fall sharply, and the VIX is typically at low levels during more stable or bullish markets, when investors aren’t too worried. When investors are worried, they will clamor to purchase options for protection, and options premium rises. You can trade futures on the VIX to speculate on potential movement in the S&P 500, or as a hedge for your equity portfolio during times of heightened volatility.

If you trade options, you probably know about the Black Scholes model of options pricing, which includes an estimate of volatility. The model’s limitation is that it must use an estimate for volatility in calculating the theoretical option premium, and that estimate may or may not bear out. The Chicago Board Options Exchange (CBOE), where most options in the U.S. are traded, developed a model to solve for the expected volatility using options prices in the S&P 100 and S&P 500.

The formula for VIX is very different from the Black-Scholes implied volatility familiar to option traders. VIX is based on a weighted sum of option prices, while in the Black-Scholes model, implied volatility is backed out of an option price. Traders would use historical volatility to estimate future volatility, but we know the market is constantly changing and what happened in the past may not happen the same way in the future.

The CBOE Volatility Index is based on real-time prices of options on the S&P 500 Index listed at the CBOE, and is designed to reflect investors’ consensus view of the future (30-day) expected stock market volatility. The market has more information than any one individual, and tends to be a more effective way to measure volatility. VIX uses near-term and next-term out-of-the money SPX options with at least 8 days left to expiration, and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index. VIX futures are traded on the CBOE Futures Exchange (CFE).

The futures contract size is $1,000 times the index. So if the VIX is trading at 20, the notional value of a futures contract is $20,000. If the index went to zero (although theoretically impossible), you’d lose $20,000 if you were long the VIX futures from $20. Regular trading hours are similar to other stock index products, from 8:30 a.m. – 3:30 p.m. CT. View full contract specs at: http://cfe.cboe.com/Products/Spec_VIX.aspx

VIX futures gain or lose value based on the price of the volatility index. Futures offer a useful tool to hedge a portfolio against market volatility. During the financial crisis in 2008 we saw a huge spike in volatility, reflected in the price of the VIX, which rose above 80. During the later part of 2009, the stock market grinded higher and we reached a low-volatility level. At that time, the VIX was trading in the teens and low 20s.

The noise about the sovereign debt crisis in Europe this spring created another spike in volatility, and the “flash crash” in the first week of May brought the VIX back up toward 50. You can see how the VIX levels correspond with peaks and valleys of the S&P 500 in the chart below. The VIX is in red, and you can follow its price on the left side of the chart. The S&P 500 is in black, with its price levels on the right. You can see how these two tend to be inversely correlated during times of sharp price movement, so trading futures on the VIX can offer investors a valuable hedge.

Volatility Index Vs. S&P 500 Index

Why Trade VIX Futures

There are many signs right now that volatility will remain high in the market. If we do experience a sovereign debt crisis, it is difficult to protect yourself if you are a buy-and-hold investor. Stocks as well as most commodities tend to drop together in times of market panic because investors flee all assets they perceive to be risky.

The VIX futures can help insulate investors against this type of scenario. If you maintain a long position in the VIX, at times when the stock market grinds higher, the VIX will trade in a normal, low volatility range. But during unsettling times when options premium spikes, the VIX will move up dramatically and your long futures position can help offset losses you might have in stocks or other areas of your portfolio.

You might be thinking that you can just short S&P 500 futures instead. That approach might be fine if you basically just want to neutralize your portfolio during a bear market. You would gain on your futures position while the stock market drops, and lose money on your futures position when the stock market rises.

In contrast, the VIX only moves dramatically when there is a perception of risk in the marketplace. It offers a fairly strong inverse correlation when the stock market declines sharply. However, when the stock market grinds higher, the VIX typically trades in a tight range. It does not always trade inversely to the stock market in that case. The VIX can also climb even if the S&P doesn’t drop. Any time options premiums increase, due to perceived risk, you can profit from that scenario if you are long VIX futures. We do typically see option premiums spike when the stock market declines rapidly, but the point is it’s not always a one-to-one direct correlation.

This is a just a brief introduction to the VIX and how you might find trading VIX futures beneficial. There are many strategies you can pursue, and I encourage you to learn more.

Aaron Fennell is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at afennell@lind-waldock.com.

The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors. Past performance is not indicative of future results. Please carefully consider your financial condition prior to making any investments. Not to be construed as solicitation.

Lind-Waldock, a division of MF Global Canada Co.

MF Global Canada Co. is a member of the Canadian Investor Protection Fund.

(c) 2010 MF Global Holdings Ltd.

CBOE VOLATILITY INDEX^® (VIX^®) OPTIONS

Symbol:
VIX

Underlying:
The CBOE Volatility Index - more commonly referred to as "VIX" - is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500^® Index (SPX) option bid/ask quotes. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.

Multiplier:
$100.

Strike Price Intervals:
Minimum strike price intervals of not less than $1.00 are permissible, subject to certain conditions. (See CBOE Rule 24.9, Interpretations and Policies .01 for more complete information) Otherwise, strike price intervals shall not be less than $2.50.

Strike (Exercise) Prices:
In-, at- and out-of-the-money strike prices are initially listed. New strikes can be added as the index moves up or down.

Premium Quotation:
Stated in points and fractions, one point equals $100. Minimum tick for series trading below $3 is 0.05 ($5.00); above $3 is 0.10 ($10.00).

Expiration Date:
The Wednesday that is thirty days prior to the third Friday of the calendar month immediately following the expiring month.

Expiration Months:
Generally, up to three near-term months plus up to three additional months on the February quarterly cycle.

Exercise Style:
European - CBOE Volatility Index options generally may be exercised only on the Expiration Date.

Last Trading Day:
The Tuesday prior to the Expiration Date of each month.

Settlement of Option Exercise:
The exercise-settlement value for VIX options (Ticker: VRO) shall be a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices of the options used to calculate the index on the settlement date. The opening price for any series in which there is no trade shall be the average of that option's bid price and ask price as determined at the opening of trading. Exercise will result in delivery of cash on the business day following expiration. The exercise-settlement amount is equal to the difference between the exercise-settlement value and the exercise price of the option, multiplied by $100.

Position and Exercise Limits:
No position and exercise limits are in effect. Each member (other than a market-maker) or member organization that maintains an end of day position in excess of 100,000 contracts in VIX for its proprietary account or for the account of a customer, shall report certain information to the Department of Market Regulation. The member must report information as to whether such position is hedged and, if so, a description of the hedge employed e.g. stock portfolio current market value, other stock index option positions, stock index futures positions, options on stock index futures; and for customer accounts, provide the account name, account number and tax ID or social security number. Thereafter, if the position is maintained at or above the reporting threshold, a subsequent report is required on Monday following expiration and when any change to the hedge results in the position being either unhedged or only partially hedged. Reductions below these thresholds do not need to be reported.

Margin:
Purchases of puts or calls with 9 months or less until expiration must be paid for in full. Writers of uncovered puts or calls must deposit / maintain 100% of the option proceeds* plus 15% of the aggregate contract value (current index level x $100) minus the amount by which the option is out-of-the-money, if any, subject to a minimum for calls of option proceeds* plus 10% of the aggregate contract value and a minimum for puts of option proceeds* plus 10% of the aggregate exercise price amount. (*For calculating maintenance margin, use option current market value instead of option proceeds.) Additional margin may be required pursuant to Exchange Rule 12.10.

CUSIP:
12497K

Trading Hours:
8:30 a.m. to 3:15 p.m. Central Time (Chicago time). CBOE Volatility Index options will not open until the SPX opening rotation is completed.