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Vetting VIX Options

Buying VIX calls may prove prohibitively expensive. Selling VIX puts might be an interesting proposition.

Editor's Note: The following is an exclusive reprint of market commentary posted at SchaeffersResearch.com on Feb. 1.

Earlier this month, the Chicago Board Options Exchange (CBOE) said it would launch options on the CBOE S&P 500 Volatility Index (VIX) on Feb. 24. Here are some possible repercussions from the introduction of VIX options, from my vantage point.

It seems to me that the primary players in these VIX options under "normal circumstances" will be call buyers or put sellers. I'd define "normal circumstances" as a period during which the market has been range trading with a slight upside bias and the VIX has been range trading with a slight downside bias, (i.e., the environment of the past two years.)

VIX call buyers would be looking to profit from sharp and rapid declines in the market that produce even sharper rallies in the VIX. VIX put sellers would be betting that the VIX will not decline below a particular level -- I would imagine that put selling at the 10 strike would be a very popular endeavor.

Who would rationally want to sell calls on the VIX? Even if you're expecting the market to break out to the upside, it would appear to make little sense to be a VIX call seller for two reasons:

Risk: The convexity of VIX options in the event of a market plunge would far outstrip that of conventional index options. Not only could the absolute level of the VIX double or triple (or more), but the volatility of the VIX has reached levels well above 100 percent in such situations -- double its normal volatility of 60% to 70%.

The mitigating factor here is the fact that the volatility of the VIX is high, which means that VIX option premiums should be rich. We may also see some significant skews whereby VIX calls are priced much more aggressively than VIX puts. This could entice covered-call sellers looking to generate income on large-cap portfolios. So in the end you could have a decent mix of VIX call sellers with call buyers, as potential sellers are attracted by the rich premiums and potential call buyers are repulsed by these premiums.

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Uncertainty of reward: It is not at all impossible for the VIX to actually rally on a major market breakout to the upside. This could be due to a number of factors, including a massive throwing in of the towel by call premium sellers who had become convinced that the market was going to range trade with a slight upside bias forever.

Who would rationally want to buy puts on the VIX? Can the VIX decline much below 10? Perhaps put premiums would become too low for buyers to resist as a result of all those who might be willing to be put sellers, but it's pretty hard to get excited about the profit potential of the long VIX put trade unless these premiums became truly minuscule.

Additionally, I suspect that the new VIX options might mitigate the large negative volatility skews we still have among out-of-the-money index options. I think these skews are due in part to the inability of market makers to adequately hedge the catastrophe risk of being short these index puts, and if they can buy VIX calls as a hedge, perhaps the cost of plain vanilla index puts comes down.

With the huge caveat that much will depend on the pricing of these new VIX options, I would (at least initially) advise against selling VIX calls or buying VIX puts. And buying VIX calls may prove to be prohibitively expensive. Selling VIX puts might prove to be an interesting proposition, as there is no explosive "event risk" that can blow up this trade and the case against a single-digit VIX is a strong one, regardless of future market direction.

Bernie Schaeffer is Chairman and CEO of Schaeffer's Investment Research, Inc. and author of The Option Advisor: Wealth-Building Techniques Using Equity and Index Options. Bernie has edited the Option Advisor newsletter since its inception in 1981.

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