The VIX, or Chicago Board Options Exchange (CBOE) Volatility Index, consists of a real-time market index representing the market’s expectation of 30-day forward-looking or implied volatility in the stock market.
Many professional investors, hedge fund managers, individual traders and speculators use the VIX to measure market risk ahead of taking action in the stock market. Option market makers and risk managers might also use the VIX to lay off exposure to implied volatility in their S&P 500 options portfolios.
If you have an interest in trading VIX options, keep in mind that how you trade VIX options is just as important as where you trade, so make sure you pick the right options broker for your needs.
Main Takeaways: How To Trade VIX Options
- Study the VIX Index. Look at the past performance of the Index using technical analysis before making any real trades.
- Decide on a trading strategy. Depending on the current market conditions, decide the strategy you will use to make your trades.
- Use a reputable broker. Find a broker, like Interactive Brokers, that allows you to trade in the style you're comfortable with.
- Practice with a demo account and test your plan. Utilize the strategy you've selected with a demo account before trading live. This way, you can ensure your plan is effective while avoiding losses during the trial.
- Start live trading. Once you're confident in your understanding of the VIX Index and your strategy, you can begin trading.
Trading VIX Options: What to Know First
Volatility is a vague concept that relates to the degree of variation in the price of a tradable asset over a period of time for most people.
Put simply, the riskier the tradable asset, the higher the volatility.
Furthermore, historical volatility, which is also called known or statistical volatility, can be measured objectively for a given past timeframe. This is done by computing the standard deviation of price changes observed on some basis (say from close to close) and then annualizing the result.
Most importantly for VIX option traders, implied volatility is the level of volatility for a particular future time frame. This is implied by option prices for that same time frame using an options pricing model, like the Black Scholes model.
You’re trading options on implied volatility for S&P 500 options when you trade VIX options.
Options are contracts with an expiration date and a value determined by the price of an underlying asset. The asset underlying VIX options are VIX futures contracts of the same delivery date.
Positions in the underlying VIX futures contracts are always offset before the delivery date or offset in cash on the delivery date since there can be no delivery of the index. Also, options expire worthless if transacting at their strike price is less favorable than at the prevailing underlying market on their expiration date and time.
Step 1: Get Familiar with the VIX Index
Before you start trading — and even before you find a broker — study the VIX Index’s past performance and how other traders speculate on both the futures and options on the index.
Getting a good handle on the underlying index before trading options on the index also makes perfect sense. Like virtually any market, the VIX Index can be analyzed using technical analysis.
On a fundamental level, the index tracks the implied volatility of the S&P 500 options. It will therefore typically rise to reflect a higher level of fearful emotions and a growing state of uncertainty in the market and it will decline to signal a reduction in the level of those risk-related factors.
A good way to get familiar with how the index trades is to watch it during periods of market uncertainty. Do this during a major stock market selloff, as shown in the image below, or after the release of a significant economic number.
Once you have an idea of how the index reacts to moves in the underlying market, you can then consider what option strategy you might apply.
Step 2: Compare Option Strategies
Options trading strategies vary and can be implemented for up markets, down markets and sideways markets. It’s important to be aware of what type of market conditions you will be trading in.
For example, consolidating markets tend to depress implied volatility, while sharply moving markets tend to boost it.
In addition to the prevailing market environment, be aware of what risk events an option’s lifetime encompasses. These are important upcoming economic releases or anticipated major events, such as elections or referendums, which might take place over the duration of the options you trade.
Beginners might want to stick to simple call and put buying to take advantage of directional moves in the VIX Index.
More experienced traders might be comfortable spreading by buying and selling options simultaneously for a credit or debit. Spread strategies limit your returns but also limit your risk. Find the best strategy for your goals and develop a trading plan you can stick to that incorporates the strategy.
Step 3: Find a VIX Options Broker
After researching volatility, the VIX Index and basic option strategies, find a reputable broker. Regulation and oversight would probably not be an issue since any broker dealing in VIX options must be registered with the CBOE and the Options Clearing Corp. (OCC).
Make sure the broker you select has oversight on the major U.S. regulating agencies such as the National Futures Association (NFA), the Securities and Exchange Commission (SEC) or the Commodities Futures Trading Commission (CFTC).
Interactive Brokers is one of the most affordable brokers to trade options through if you have a large enough margin deposit to qualify for an account. You can also trade VIX futures in your Interactive Brokers account at $1 per option. Interactive Brokers also offers tiered commission for traders who do large-volume trading.
Step 4: Open a Demo Account
In addition to allowing you to develop a trading plan, a demo account allows you to test your trade plan in real time. This can give you important insight into your trading plan and lets you make changes before trading in a live account. Once you’ve selected a broker and opened a demo account, you can then work on developing a trading plan.
This can give you important insight into your trading plan and lets you make changes before trading in a live account. Once you’ve selected a broker and opened a demo account, you can then work on developing a trading plan.
Step 5: Develop and Test Your Trading Plan
A VIX options trading plan can simply consist of call and put buying to take a directional position on the VIX. Options strategies are quite varied and several can usually be applied to any market environment or view.
Keep in mind that option contracts do expire, and the often-considerable time value component of price must be taken into account in any strategy, especially if you intend to close out the position prior to expiration.
Trading options involves 3 main strategies when it comes to premium or time value. You can buy premium, sell premium and use premium neutral strategies.
Buy Premium Strategy
Buying premium means that you expect a move in the market that would make the options you own appreciate significantly in value.
Such appreciation will generally involve the underlying market moving to trade at a less attractive level than the strike price of the option you purchase by its expiration. When trading options, appreciation on a long option position can also reflect a rise in implied volatility.
Sell Premium Strategy
Selling options premiums generally involves receiving premium income in return for accepting risk, which can be unlimited if you sell naked options.
As a result, most brokers require considerably more margin if you wish to take short options positions. If that presents an issue for you, option spreads let you sell an option against another purchased option, so it requires that you both buy premium and sell it, although at different strike prices.
Premium Neutral Strategy
You can also combine futures positions with options. This strategy requires that you open a futures account and involves even higher costs to margin VIX futures contract positions. For example, holding an overnight position in a VIX futures contract in your trading account can cost as much as $20,000 in margin.
One way around trading futures consists of using a spread of a deep in the money call versus a put as a synthetic substitute for a futures contract.
After working out your strategy and developing your trading plan, you can test your plan in a demo account offered by your chosen broker. Once you’re satisfied that your strategy can be profitable and have successfully tested your trading plan in the demo account, you’re ready to start trading VIX options in a live account.
Step 6: Take Your Winning Strategy Live
Be sure you feel thoroughly prepared and confident enough in your trading plan to risk real money.
When you eventually do start trading in a live account, it usually makes sense to begin by risking only small amounts to build up your confidence and to gauge how you deal with the various emotional issues that can arise when trading.
One of the main reasons to develop a trading plan is to make sure that your emotions take a backseat to your chosen trading strategy and develop the discipline to follow that trading plan to have the best chances of success.
Keep in mind that your results in a demo account may differ considerably to your live trading results depending on a number of factors that include your state of mind and discipline level.
Use Hope and Fear to Your Advantage
Unlike any other trading vehicles, VIX options and futures give you the opportunity to trade the level of fear in the broad U.S. stock market. VIX options also give you many more strategic alternatives and additional leverage to trading plain futures contracts.
While trading VIX options may not be for everyone, option traders with a solid strategy and trading plan could do extremely well trading the underlying stock market volatility index and its options.
Frequently Asked Questions
What are the best avenues for trading the VIX?
The best ways are to buy ETNs and ETFs tracking the VIX.
When are the best times to trade the VIX?
The best times are when the VIX is at its lows or highs.
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