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On Options

5 Myths of Volatility Options

Schwab’s VP of Trading & Derivatives Randy Frederick busts some common misconceptions about volatility options.

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Previously, I've written about the CBOE Volatility Index® (VIX®)—covering its introduction in 1993, the formula change in 2003, the introduction of futures on the VIX in 2004 and finally options on the VIX in 2006.

I've also discussed how different VIX options are from other exchange-traded options. Oftentimes the (historical) volatility of volatility can reach exceptionally high levels when the markets go through periods of instability. The VIX ($VIX) tends to be very sensitive to quick reversals in the market.

For example, we can see that the 20-day historical volatility of the VIX (represented by the blue line in the chart below) was over 200% in 2008, 2010, and 2011, compared to its lows of around 50% during this time period. This is considerably higher than the volatility of virtually any stock in the marketplace.

The VIX Itself Has Been Volatile

The VIX Itself Has Been Volatile

High volatility and changes in volatility create all sorts of risks, but they can also create opportunities for using volatility options to hedge against (or speculate on) sharp swings in the marketplace. As a result, the volume of options traded on the VIX has grown tremendously every year since they were introduced. 

Even though the VIX is primarily an institutional product, retail volume of VIX options has been rising steadily as well. However, the unique nature of volatility options continues to cause problems for retail options traders. Let's tackle five common myths.

Myth 1: Because the VIX is an index, volatility options on the VIX are priced just like any other index option

Not true. These volatility options are intended to reflect the expected volatility level at option expiration, not the current volatility. The value of a VIX option is an estimate based on S&P 500 (SPX) options prices.

While this methodology may cause the options to increasingly reflect the spot volatility index quote ($VIX) as they approach expiration, they typically won't match the spot volatility quote until they are just about to expire. As a result, despite the significant volatility spikes that may occur in the market, volatility options generally reflect a much different level of volatility than you might expect—possibly half as much or twice as much.

Additionally, since volatility tends to revert to its long-term mean over time, even when volatility spikes sharply it isn't likely to remain that high for long. In other words, when the markets are temporarily more volatile than normal, the most likely development is for them to settle down. Likewise, when the markets are unusually quiet, the odds are pretty good that volatility will pick up in the near future.

Myth 2: I trade volatility options, but I don't have a futures account and don't trade futures, so I don't have to pay attention to the futures market

You should. Volatility options are not futures options, but as noted above VIX options are based on a future volatility level rather than the spot index ($VIX) quote. Therefore a better gauge for pricing VIX options may be to view the VIX futures contract for the same or next expiration month rather than the current cash VIX index. Unlike options, futures contracts do not include any time value. Instead, they are priced based on the cost of carry, which is the aggregate value of dividends and interest rates from the current date until expiration.

The best source for volatility futures quotes may be directly on the CBOE Futures Exchange (CFE). Quotes on this website are free, but typically delayed by 10 minutes. Symbols and expiration dates are different for futures than for securities, so below is a brief explanation of futures symbology.

Futures symbols

Format: Commodity symbol / expiration month + year digit
Example: VIX/Q3 is the VIX futures contract that expires in August 2013
Futures expiration month codes:
January F
February G
March H
April J
May K
June M
July N
August Q
September U
October V
November X
December Z

Myth 3: Since volatility options are securities index options, the pricing models I use to estimate the value of these options will work the same as they do for other index options

This is not always the case. For instance, if you trade using StreetSmart Edge and are familiar with Theoretical View (shown below), when you try to estimate the value of a volatility option using this tool, you may get inaccurate information during times when the underlying index is well above or well below its long-term average as shown below.

VIX Options in Theoretical View

VIX Options in Theoretical View

Theoretical View treats VIX options like any other index options. As a result, it's important that you do not consider discrepancies as trading opportunities. The tool uses $VIX as the underlying index, but pricing is actually based on VIX futures. When the $VIX index is close to the same level as the VIX futures, the tool may be fairly accurate. However, when they are different, it may not.

That said, if you find the pricing models are not working, you may be able to get a more accurate estimate of how much the option may be in the money or out of the money if you change the underlying share price from the spot VIX quote to the VIX futures price, as shown below.

Using the VIX Futures Price Instead

Using the VIX Futures Price Instead

Myth 4: Even though futures don't carry any time value, volatility options will still reflect proper time values because they are securities options

Unfortunately, you can't assume that volatility options will reflect proper time values like other options. Because volatility options are most closely related to their corresponding futures prices, the time value these options carry is affected accordingly. This anomaly can make volatility options with more distant expiration dates appear "cheaper" than options that expire sooner, and sometimes VIX options may even appear to be trading at a discount to their intrinsic value, neither of which is true.

As a result of this time value peculiarity, you can't create a standard calendar spread on volatility options, because it might be possible to do so at a net credit. As you can see in the example below, because long-term futures prices are less sensitive (than the VIX index) to short-term volatility changes, December '12 puts with a strike price of 17 can be sold for $0.40 higher than the purchase price of January '13 puts with a strike price of 17. 

A Time Value Anomaly

A Time Value Anomaly

When calendar spreads are created, Schwab will consider the short leg of the spread uncovered (naked) for purposes of calculating margin requirements.

Myth 5: Expiration dates never vary on options contracts, so at least this is true for volatility options

Wrong again. Volatility options expire on the Wednesday that is 30 days prior to the third Friday of the calendar month immediately following the expiration month. For months with four Fridays this means volatility options will expire on the Wednesday before the regular equity option expiration date (the Saturday following the third Friday of the month) and for months with five Fridays they'll expire the Wednesday after the regular equity option expiration. Since option symbols now include the exact expiration dates, be sure to take note. More information regarding expiration date methodology is available on the CBOE volatility website.

The bottom line

While everything above relates to options on the VIX, it also applies to options on other volatility indexes. In recent years CBOE has traded options on the Russell 2000 Volatility Index ($RVX) and the NASDAQ Volatility Index ($VXN), and they currently trade options on the Crude Oil Volatility Index ($OVX) and Gold ETF Volatility Index ($GVZ).

Of course, I couldn't possibly cover all of the nuances and peculiarities of volatility options here. Before you decide to trade them, I strongly recommend you visit the CBOE volatility website.

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