The Volatility Index (VIX)
Volatility Index options are a refreshing innovation that allows an option trader a spectacular trading opportunities that are rarely present in other option markets.The index is based on the implied volatility present in 30 day S&P 500 options. In efficient markets this can reliably be seen as the markets expectation of near term volatility, and once the index is created traders are able to implement a view of volatility that is isolated from other variables that are common to option pricing such as underlying asset prices, dividends, and even days to expiry. With the VIX, volatility has been transformed into a commodity, and can be apprehended without the complexities of hedging an option in order to capture the extrinsic value, and then set about funding the position. The VIX allows a straight purchase or sale of volatility, which if anything, removes the skill of trading volatility; a prerequisite that has deterred so many traders to date.
The VIX shares an intriguing relationship with the S&P. Indeed, it is true of all equity markets that they rise at a far slower rate than they fall, and as such, the historical volatility of the S&P is found to be inverse to its price. Immediately it can be seen that the VIX is the perfect hedging device for equity markets, and moreover offers the classical economist the true diversification they so strongly advocate.
Marvelously, the VIX also trades within a strict range of between 10 and 45 (reflecting volatility as a percentage). Similar to a stock, the VIX is unable to contemplate low extremes toward zero due to the implication that implied volatility in the S& P will be zero and so remain unchanged. This unlikely event preserves the VIX as one of the only assets that can be relied upon to always carry a value. Every equity index will experience the usually humdrum of the trading day. This may continue into weeks and months, but out of the entire option delivery month there may be one day that volatility sky rockets to outrageous levels, and the market undergoes a significant move. Further, the implied volatility of index options will remain at comparatively high levels suggesting up to 25% with ease. Of course, when historical volatility rarely reaches such levels the advantage is clearly with the grantor of options. Still, that one day of mayhem where historical volatility reaches 50-60% will eradicate any profits made from the prior diligent selling of premium.
As to the VIX, it matters not that the correlation between the implied volatility of index options and that of the underlying index is not synchronized. The VIX relies on only one factor; the volatility implied by premiums traded in index option markets. The historical volatility of the index itself is of no import, but a perfected market will bring the two into line in the long term. Under these conditions, the IX is sure to offer value when it is absent in many other markets.
The VIX shares an intriguing relationship with the S&P. Indeed, it is true of all equity markets that they rise at a far slower rate than they fall, and as such, the historical volatility of the S&P is found to be inverse to its price. Immediately it can be seen that the VIX is the perfect hedging device for equity markets, and moreover offers the classical economist the true diversification they so strongly advocate.
Marvelously, the VIX also trades within a strict range of between 10 and 45 (reflecting volatility as a percentage). Similar to a stock, the VIX is unable to contemplate low extremes toward zero due to the implication that implied volatility in the S& P will be zero and so remain unchanged. This unlikely event preserves the VIX as one of the only assets that can be relied upon to always carry a value. Every equity index will experience the usually humdrum of the trading day. This may continue into weeks and months, but out of the entire option delivery month there may be one day that volatility sky rockets to outrageous levels, and the market undergoes a significant move. Further, the implied volatility of index options will remain at comparatively high levels suggesting up to 25% with ease. Of course, when historical volatility rarely reaches such levels the advantage is clearly with the grantor of options. Still, that one day of mayhem where historical volatility reaches 50-60% will eradicate any profits made from the prior diligent selling of premium.
As to the VIX, it matters not that the correlation between the implied volatility of index options and that of the underlying index is not synchronized. The VIX relies on only one factor; the volatility implied by premiums traded in index option markets. The historical volatility of the index itself is of no import, but a perfected market will bring the two into line in the long term. Under these conditions, the IX is sure to offer value when it is absent in many other markets.
Posted by The Options Hunter Blog at 5/13/2010 9:52 AM 
Categories: vix options
Tags: volatility options
Categories: vix options
Tags: volatility options
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