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How Are Volatility Products Priced?

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One thing Mark Sebastian and I spend a lot of time talking about and teaching at Option Pit is deciphering the direction of the volatility products. The more traders understand how options work, the more they are interested in how volatility affects the option prices. Once they start to understand that then we teach them about the volatility products. Essentially they are a derivative of a derivative of a derivative when we are talking about the options on a volatility ETF or ETN like the ProShares Ultra VIX Short-Term Fut ETF (UVXY) or the iPath S&P 500 VIX ST Futures ETN (VXX). Think of an onion with a lot of layers and slowly but surely keep peeling back the skin until you get to the good stuff underneath.

First understand that the volatility per strike in the SPX is different and changing on a sloped curve known as the "skew". This in turn generates a weighted average of the implied volatility around the at the money (ATM) for the SPX known as the CBOE Volatility Index (VIX). The VIX is a 30-day constant duration so it uses the options in the SPX that approximately straddle 30 days.

I am using an OptionVision screen below to show the curve in the near term strike months. The "buildings" are implied volatility per strike so note how the implied volatility rises as the puts get more out of the money.

3D chart by ORATS/Aqumin (

If you note the midday activity the red strikes (calls on the left, puts on right) have declining volatility. The ATM IV change was pretty muted today but there was a little shift in downside for Dec (slightly up) and the downside for Jan (slightly down). A turn in the VIX should happen between those two terms. As it stands today VIX was near flat on the close as the OptionVision screen shows.

Adding the VIX future layer is the next piece. The volatility futures trade in successive month up to nine months out. The premiums in the futures over the VIX cash are loosely based on the term structure of the SPX as temporary supply and demand can push them around.

Go to and take a look at the future prices and a month in the SPX that is close in the term structure. The gist is that the VIX futures are based on forward volatility assumptions so they will have somewhat unique movement. They have a mean reverting character and do not trade like a "normal" stock.

The volatility products like the VXX or UVXY are based on these mean reverting underlying futures. Confused yet? The ETNs and ETFs that try to track the VIX futures usually pick different parts of the term structure. Some are near term, others are far term and some are levered. When we have a four-day weekend there is accelerated decay in the near term volatility which will negatively impact all of the near term VIX future-based products.

Note in the OptionVision Landscape how dark red the Implied Volatility drop was near term in the SPY. If the liquidity providers decay the options that aggressively the VIX will stay weak which will mute the future movement which in turn will hobble the volatility products like we saw on Tuesday. The trick is peeling the onion until you get to the answer.

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At the time of publication, Andrew Giovinazzi held positions in VXX.

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