What it means
The VIX is a number calculated from the prices of options on the S&P 500 index and published by Cboe (formerly the Chicago Board Options Exchange), and it reflects the market's expectation of volatility over the next 30 days. It tends to rise sharply when stock markets fall and to drift lower when markets are calm.
This is why it is often called the market's fear gauge. A call option on the VIX gains value if the index rises above the strike price (the level agreed in the contract), and a put option gains if it falls below.
Contracts are European style, meaning they can be exercised only at expiry, and they are settled in cash based on a special calculation of the index on the expiry date. Each index point is worth $100 per contract.
A feature that surprises newcomers is that a VIX option does not track the spot VIX directly. Before expiry, its price is linked to the VIX futures contract for the same expiry date, which can differ widely from the current index level.
A trader may be right that the VIX will rise yet still lose money if the futures price already assumed the rise. For a company or investor, the main use is insurance.
Buying VIX calls can offset losses on a share portfolio during a sudden fall, because the VIX typically jumps when markets drop. The cost of that protection is the premium, which is lost if no turmoil arrives.
Risks are significant. Time decay erodes the value of the options as expiry approaches, volatility itself is hard to forecast, and sellers of options can face large losses if the VIX spikes.
These instruments are generally used by experienced traders and require careful position sizing. A non-specialist should regard VIX options as a sophisticated tool whose behaviour differs from share options.
Anyone considering them should understand the futures link, the contract terms and the maximum possible loss before trading.
In practice
Real-world examples.
Example
A fund manager holding $5,000,000 of shares worries about a major central bank announcement. She buys VIX call options costing $15,000 in total, which would increase in value if markets fell sharply and volatility rose.
Example
A trader believes volatility is too high after a market sell-off and expects calm to return. He buys VIX put options, accepting that he will lose the premium if volatility instead continues to rise.
Example
A risk analyst at an insurance company reviews a proposal to hedge equity exposure using VIX options. She notes that the options are linked to futures prices, so the hedge may not move one-for-one with the portfolio, and recommends limiting the size of the position.
Formula
Calculation
Payoff of a VIX call at expiry = (settlement value - strike price, or zero if negative) x $100 multiplier
A trader buys one VIX call option with a strike of 20 for a premium of 2.00 index points, so the cost is 2.00 x 100 = $200. At expiry, the settlement value is 28. Payoff = (28 - 20) x 100 = 8 x 100 = $800. Profit = 800 - 200 = $600. The break-even settlement value is 20 + 2 = 22. If the settlement value were 18, the call would expire worthless and the loss would be the whole $200.Case study
Seen in the real world.
Brightstone Pension Partners is an illustrative, fictional fund managing $200,000,000 in shares. The investment committee wanted protection against a sudden fall without selling its long-term holdings.
The risk manager proposed spending 0.25% of assets, or $500,000, on VIX call options with expiries spread over several months. In a calm year, the options expired worthless, costing the fund $500,000, or 0.25% of assets, which the committee regarded as the price of insurance.
In the following illustrative year, a sharp sell-off lifted the VIX, and the options gained $2,000,000 while the share portfolio fell 4%, or $8,000,000. The hedge offset a quarter of the loss, and the committee decided to continue the programme with a similar budget.
Watch out
Common mistakes.
- Assuming the option price follows the spot VIX, when it is linked to VIX futures for the same expiry date.
- Holding the options for too long, when time decay steadily reduces their value if nothing happens.
- Buying too many contracts as a hedge, so that the premium becomes a large drag on returns in quiet markets.
Questions
People also ask.
Can you exercise a VIX option early?
No, they are European style, so they can only be exercised at expiry, but they can be sold at any time before.
Are VIX options settled in shares?
No, they are settled in cash based on the settlement value of the index at expiry.
What does the VIX actually measure?
It measures the market's expectation of S&P 500 volatility over the next 30 days, derived from the prices of index options.
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