Trading volatility seems pretty straightforward for option traders. We have the:
(VIX), and we have the CBOE Volatility Index. There are options on it--trade 'em up! But not so fast. VIX options might not work quite like you think.
The quirk about VIX options lies in the specific underlying used. Strangely, the underlying for VIX options is not the VIX Index. It is the future value of the VIX at expiration. This is a big difference--a really big difference.
The actual VIX Index is very volatile, moving a great deal each day. But you wouldn't know it from looking at its options; they move as if the VIX doesn't move very much. The erratic daily jumps and drops are smoothed out of the valuation of the options because the valuation is based on the value of the VIX at a point in the future. One big spike today doesn't matter when the price is based off the value a month from now.
One can easily observe the valuation quirk with a little help from an option chain and a basic understanding of synthetics. Note this chain
If the VIX is at 42.41 (and considering there is only a tiny interest rate consideration for an index) put-call pairs should show a synthetic underlying equaling roughly that price. But, it doesn't. Using market midpoints, the 42.5 strike shows a 2.30-valued call and a 10.45-valued put. That means the implied underlying is 34.35 (that's 42.5 + 2.30 - 10.45). That's far below the actual VIX index value. Thus, a trader who expected the VIX to rise above 40 who bought calls wouldn't profit nearly as much as he expected if he was watching the index and expecting the call to revaluate relative to it.
At the time of publication, Dan Passarelli held no positions in the stocks or issues mentioned.
Dan Passarelli, is the author of the book Trading Option Greeks and founder of Market Taker Mentoring LLC. Market Taker Mentoring provides options education, including personalized, one-on-one mentoring for option traders. The company website is http://www.markettaker.com.
Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as an equity options market maker. He also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT). In 2005, Dan joined CBOE's Options Institute and began teaching both basic and advanced trading concepts to retail traders, brokers, institutional traders, financial planners and advisors, money managers, and market makers. In addition to his work with the CBOE, he taught options strategies at the Options Industry Council (OIC).
He can be followed on Twitter at twitter.com/Dan_Passarelli.