In Part 1 of this primer, I dissected the Chicago Board Options Exchange's proposed strategies for using the new VIX future and illustrated some potential problems. However, that doesn't render the product completely useless. In fact, it can create some interesting opportunities for astute traders.
Here, I'll tackle some common questions about the VIX future and discuss five ways you can use it once it hits the market on March 26. Can the future be used to gain pure implied volatility exposure? Volatility traders (as opposed to directional traders) of S&P 500 index options derive profits from two components: a change in the implied volatility and realized volatility captured by hedging their positions. This future only calculates the change in forecast implied volatility and will not reflect any captured (realized) stock-price movement. This is a critical point to understand before considering this product's "pure implied volatility." Implied volatility may be a large factor in long-dated options, but it's relatively insignificant in the front months used in the VIX. Realized volatility is the primary factor of profitability in front months. Front-month straddle buyers generally buy for the event, not the post-event change in implied volatility. Options held to expiration will only be profitable if the realized volatility is greater than the implied volatility initially paid -- or, put more simply, hedging profits will be greater than the price paid for the options. Investors buying the actual S&P 500 index options will be able to capture that movement while future buyers will not. Can the future be used to hedge against short-term options positions? VIX futures aren't a reliable hedge for this usage. Here's an extreme example of how the suggested hedge (short options, long future) could exacerbate losses. Last July 24, Roche acquired Igen International. Igen's stock price jumped from $37 to $59, while the implied volatility collapsed from 80 to 30. A trader selling an August 35 straddle for $6 would have lost about $18. Volatility decreased because the price of the acquisition was fixed, and the stock was now expected to be stable. Future buyers would not only fail to participate in the positive stock movement, but also lose money because the implied volatility fell. This type of loss is unpreventable with the future.