Wheels within Wheels
The art of option trading is made ever so much easier by technology with most traders using a pricing model to generate benchmark prices. Of course these prices rely not only upon a volatility variable, but also particular variables not the least of which are the price of the underlying instrument, interest rates, dividends and days to maturity. The VIX on the other hand seeks to eradicate these additional dependencies by providing an option market that isolates volatility.
When trading ordinary equity option markets or equity index markets, volatility is inherently high but is merely one of the many idiosyncratic influences on investment analysis. Liquidity, open interest and behavioral aspects of the option market will play an equally relevant part in directing a trader’s intuition. Trading the VIX however, appears to relieve the trader of having to factor in contingencies to an option trade that will otherwise need to be addressed in the future. For example, that equity volatility routinely collapses when the underlying market appreciates has always proved to hamper the buying of out-of-the-money call options in a bid to initiate a long volatility position. Similarly, out-of-the-money puts invariably trade at extremely high volatility due to the skew that incorporates the mayhem of a stock market crash. To use these as a method of selling volatility may be mathematically sound however, when the market actually does reach those levels, volatility is redefined to send chills up the spine of the most seasoned trader. In the panic of a major equity collapse it is more a case of survival than calculating volatility. Even more so than the upside counter scenario, the downside volatility contingencies that will be faced will find the most progressive of pricing models most wanting.
Within this framework the VIX provides the perfect antidote. It isolates volatility to be traded alone without the influence of underlying instruments and unique market behavior. As the VIX is an estimate of price movement in the S&P500 of one standard deviation into the 30 day period approaching expressed as an annualized price range. As such the VIX contradicts the premise that an underlying instrument is absent as the VIX itself is the underlying instrument to the options upon it. It is here that volatility is isolated and the trader is free of external influences. Call options on the VIX will be the right but not the obligation to a long position in the VIX i.e. a long position on the volatility of the S&P500. Put options will provide opportunities to implement sold positions in the VIX; the volatility of the S&P500. Regardless of whether S&P500 option volatility moves up or down in response to underlying market movements, the historic volatility in the underlying S&P500 will be determinative of a VIX option position.



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