In watching the major business networks, reading the trade magazines and even reading some of the

OptionsProfits

team's work, I wanted to make sure that everyone was well aware of how the two most popular volatility-based products operate because in the case of the

CBOE Volatility Index

I:VIX

and the

iPath S&P 500 VIX Short-Term Futures ETN

(VXX) - Get Report

, there are some unique characteristics of the two products that I feel is imperative for the reader to understand. In order to do so, I will also have to talk a little bit about the VIX futures.

The VIX futures are an interesting product. Without getting too deep into some of the idiosyncrasies of the futures themselves, I want to introduce the readers to a term called "contango." This is a situation where the front-month futures are lower in price than the back-month futures. In traditional futures products based on equities, this condition is almost always based on carrying cost (interest minus dividends). Currently, the VIX futures are in contango. The outside observer might say, "So what?"

Here is the issue: Since the VIX futures are based on implied volatility, there is no real "carrying cost." The contango in this case is based on what the market's perceived future fear might be. This means the VIX futures are usually priced higher than the "cash" index. The VIX closed at $19.27 on Thursday, while the November futures closed at$22.00. That is a full 2.75% higher! Adding to the complexity, the contango gets worse as the futures get further out in time. The March futures closed trading on Thursday at $28.90. That is more than 9 points higher than the current VIX. Contango causes two tendencies in the futures that usually catch traders by surprise.

1. It causes what almost feels like theta decay in the VIX futures. As time passes, the futures slowly get closer and closer to the cash VIX. For example, if the VIX stays at $19.27, the March Futures will have to get near $19.27 by expiration. In January, the futures might be trading at 25; in February, 22; and the day before the futures expire, 20.

2. Because the futures are in contango, when the VIX increases or decreases, the futures movements are not correlated to the cash VIX index as many traders expect. And the longer one trades the VIX futures, the less correlated they are.

The above tendencies also cause many traders to miss trade and misunderstand both the VXX and the VIX.

The VXX has some major problems caused by contango. Here is why. The VXX is a combination of the front two-month futures, that is constantly rolling from front month to back month, in an attempt to constantly be long the VIX futures at 30 days to expiration. If one takes a look at what is happening during this rolling process, the contango causes the ETN to constantly be selling an inexpensive future and buy an expensive future.

Basically, because of the rules of the fund and contango, the VXX is slowly rolling itself into oblivion. I fully expect the VXX to go to zero if the ETN's rules are not changed. Thus, for traders looking to play volatility for more than a couple of days, I would NEVER own the VXX. In fact, I am shocked the VXX is not hard to borrow, as I am somewhat certain of its impending doom. Even if I were worried about a short-term increase in implied volatility, I have no problem being short this product -- which I am, via long puts and short calls.

For those who are wondering if the VIX contango could go the other way, it certainly can, but the majority of the VIX futures in existence are in contango. For those looking to trade a better ETN, I suggest researching the

iPath S&P 500 VIX Mid-Term Futures ETN

(VXZ) - Get Report

or

Barclays ETN+ Inverse S&P 500 VIX Short-Term Futures ETN

(XXV)

.

The VIX options are a different animal. The first mistake almost every trader makes is to assume the options are based on the cash index. They are not. They are based on the futures. The November options expire into a November future, which expires at the same time as the VIX options. The December options expire into December and so on and so on. This can cause the VIX options to do some very strange things and can make them difficult to trade well. Here is why:

1. Because of the different prices in contango in the futures, the trader is dealing with two types of decay. The theta decay of the options, and the slow melting of the futures toward the cash index (if the cash is higher than the future, there can be a melting upward).

2. The at-the-money (ATM) option is going to be different in every single month. Right now in March the ATM option is the 29 strike; in November it's 22.

3. Many of the trading platforms out there irresponsibly tie the VIX options analytics to the VIX cash instead of futures. It is shocking that brokerage houses that have millions of dollars in marketing fees would allow their own software to mislead their customers. Be aware that the Greeks you are looking at in many platforms are dead wrong.

4. Many platforms do not have the ability to quote the VIX futures. Again, millions for marketing, but no underlying on a very active product. In order to figure out where the futures are actually trading, the trader ends up having to calculate the combo (I laid out the proper way to do that on my blog at Option Pit.)

5. The VIX options and futures have a nontraditional expiration date.

There are several other interesting characteristics and foibles of the VIX options, these are just the big ones. That being said, these options can have some real value both as a portfolio hedge and in directional bets on volatility. Since they are so complex, that can mean that they also have opportunity. In fact the more I trade, the more I learn that the hard stuff is usually where the money is when it comes to option trading. If one wants to trade the VIX, do the homework read everything the CBOE has to offer on the VIX, and read great resources like Bill Luby's Blog,

"VIXandMORE"

, and practice, practice, practice. ... Or you could be like me and short the VXX.

Trade: With VXX trading at $13.40, buy to open VXX January 2012 10 puts for $2.45 and sell to open VXX January 2012 20 calls at $2.90.

Buy the January 10/20 risk reversal for a credit of $0.45.

At the time of publication, Mark Sebastian was long puts and short calls in the VXX.

Mark is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange, and is currently the Director of Education at The OptionPit.com and the Director of Risk Management for a private hedge fund. Mark also writes Option911.com, a popular index and equity options blog.

OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.

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