Managing and profiting on volatility

September 30, 2009 07:00 PM

One other candidate would be a diversified portfolio that is net “short premium.” This portfolio would be a beneficiary of decay in the options. A “short premium” portfolio would be subject to an increase in implied volatility. That would mean even more premium that would decay. That is not a great situation if the investor sold premium at a lower level. If managed properly, the investor could still benefit from decay without becoming insolvent in the process should a Black Swan event take place. Another reason to trade VIX options is because it has become a robust market with plenty of liquidity.

Let’s say that an investor with $1 million invested in a long-only fund purchases 100 VIX November 40 calls for $1.70. There is then a 20% sell-off in the market. The VIX pops up to 60 and the November futures are trading at 54. The November 40 calls are trading at 15.70. While the long-only portfolio loses $200,000, the VIX calls return a profit of $140,000. It turns out to be a 6% loss instead of a 20% loss.

The VIX is a real-time market estimate of expected volatility that is calculated by using the bid/ask quotes on S&P 500 index (SPX) options. VIX uses the options from the two nearby expiration cycles with at least eight 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. Both at-the-money and out-of-the money puts and calls are involved in the calculation. Zero bid calls and puts are not involved in the calculation. This means that the number of options used in the calculation is in a constant state of flux. When the market is highly volatile, investors are willing to pay something for far out-of-the-money options that they normally would not.

VIX options (VRO) are European style options that can only be exercised on the expiration day. American style options can be exercised at any time. One day each month, on the Wednesday that is 30 days prior to the third Friday of the following calendar month, the SPX options expiring in 30 days account for all of the weight in the VIX calculation.

VIX options settle on these Wednesdays to facilitate the special opening procedures that establish opening prices for those SPX options used to calculate the exercise settlement value for VIX options. The Tuesday before it is the last full day of trading. The exercise settlement value for VIX options (VRO) is a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices of the SPX options used to calculate VIX at settlement. Opening prices typically reflect actual trades. If there is no trade, then the middle of the bid/ask is used.

Only series with non-zero bid prices upon completion of the special SPX opening procedures are used in the SOQ calculation.


VIX has been used by market participants for many years as a valuable fear gauge of the market, and the various additional VIX products can be a valuable tool as well even though they are not tradeable to date. This is particularly true of the volatility measures of currencies and commodities. Because VIX is based on equities — the underlying of which will always have a long bias — it tends to be negatively correlated with the market. It looks like a measure of weakness more so than volatility at times and can shrink in the face of unquestionably volatile upward moves. Because the underlying of commodity volatility products can be sold as easily as it is bought, it can be argued that it tracks actual volatility better (see “Variety of VIX,” page 41). The traditional VIX declined steadily from the November 2008 S&P low to the March 2009 S&P low despite several sharp upward corrections that were soon reversed.

Traders can use these measures to manage their positions and risk accordingly, the same way risk managers have used the VIX for decades. The VIX on commodities and currencies may even be more valuable, as it will be a better signal of the risk in an overheated bull market.


Binary options are the latest volatility tools on the horizon. The CBOE is set to roll them out at any time. BVZ is the ticker symbol that will be used. Binary options are a fixed all-or-nothing proposition. If, at expiration, the settlement price of the VIX closes at or above the selected strike price, the buyer of a BVZ call receives $100 per contract. If the VIX closes at a price that is below the strike price on the expiration date, the BVZ call buyer receives nothing. The BVZ put buyer receives $100 per contract if the VIX settlement price closes below the strike price at expiration, and nothing if the VIX closes at or above the strike price at expiration. It is irrelevant how deep-in-the money the options are. Today the only viable volatility tools are VIX futures and options.

Keep your eyes peeled for both the binary options and the sector specific, particularly oil and gold options
on volatility.

Dan Keegan is an options instructor and head options mentor at

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About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.