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Why Trading VIX Options Requires Extra Vigilance

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I'd had the same brilliant idea that many options traders must have had. I was expecting the big downturn that did occur over this year. Since I'm a condor trader, I worried about what would happen to my condors if I woke up one morning with markets crashing.

I would hedge my trading portfolio with out-of-the-money VIX call options, I thought.

For those not familiar with the VIX, it's a measure of 30-day implied volatility currently calculated using a combination of SPX options of the closest two-month SPX options. When originally created in 1993, OEX options were used to make the calculation. The calculation is somewhat complex, but math nerds among you can view a 19-page PDF white paper that details the calculation. Sometimes called the "fear index," the VIX typically rises when markets are dropping rapidly and drops when markets move either sideways or climb in a measured way or when market participants feel complacent.

When I called my broker about the idea of hedging with VIX options about a year and a half ago, he didn't congratulate me on my brilliant idea. Instead, he warned that VIX options were difficult to trade and that, among his colleagues and clients, he hadn't heard of many who had been successful in employing the VIX as I was considering doing.

Since my broker, Michael Cavanaugh of BrokersXpress, is the most astute broker I've ever used, I paid attention when he went on to say that VIX expiration dates caught people by surprise and the settlement values themselves sometimes proved difficult to anticipate. The options' prices sometimes didn't move in concert with the VIX in expected ways.

Last month, when I attended a CBOE-sponsored seminar by Peter Lusk of the CBOE and Dan Sheridan, Lusk pointed out some of the reasons options traders were getting tangled up in VIX options trades. "VIX futures, not the VIX, are the underlying for the VIX options," Lusk said, when speaking to attendees. The CBOE's site words it this way: "The underlying for VIX options is the expected, or forward, value of VIX at expiration, rather than the current, or 'spot' VIX value." The CBOE's site counsels that "some VIX options investors look at the prices of the VIX futures [my emphasis] to gain a better general idea of how the market is estimating the forward value of the VIX."

In other words, VIX options traders can't expect the VIX options to reflect current VIX values they receive from their real-time quotes. A rise in the VIX might not see the corresponding expected rise in front-month VIX calls, for example.

Another wrinkle is added when looking at expiration calendars for the VIX. They don't expire at the usual time for equity or index options. As Lusk's presentation material states, VIX options expire "the Wednesday 30 days prior to the next month's option expiration," and stop trading the Tuesday before that Wednesday. The CBOE's site says that "VIX was designed to be a consistent, 30-day benchmark of expected volatility," and "there is only one day in the life of any option that is exactly 30 days to expiration." That day is the Wednesday "thirty days prior to the third Friday of the following calendar month," when "the SPX options expiring in exactly 30 days account for all the weight in the VIX calculation."

Special opening procedures result in a SOQ or Special Opening Quotation of the VIX. This is formulated from the opening prices, when traded, of SPX options that are used to calculate the VIX at settlement. As the CBOE's site warns, this is the only VIX calculation ever made from actual traded prices. Other VIX values are calculated using mid-quote prices of SPX options series, so the VIX expiration adds another wrinkle. Furthermore, as Lusk warns, these options are not front-month options but next-month ones. For example, he says, "November VIX settlement uses December SPX options" to calculate the settlement number. If a VIX based on futures and not on spot prices and an odd expiration and settlement date don't prove problematic enough, figuring out that likely Wednesday morning settlement value for the VIX might prove even more challenging for traders holding expiring VIX options on Tuesday.

As you might imagine, the VIX volatility suggested by front-month SPX options might be far different from those suggested by those one-month out. The exercise settlement value for VIX options has been assigned the symbol VRO.

Even the CBOE's site admits "calculating exact theoretical values for VIX options can be very complex." You don't say. It seems that just about everything about VIX options can be considered "very complex." A few weeks ago, I wrote an Options 101 article detailing some of the basics you need to know before you ever trade an option, including when they expire and stop trading and how they're settled. It would seem that with the VIX, determining such basics before you consider trading them is going to take a lot of study.

I took my broker's advice. I used other methods to control my risk. While I've heard from traders who believe trading the VIX options is a great idea, this article should make it clear why it isn't for many traders.

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