We now have trades on the Volatility Index (VIX) futures. In a more detailed post to Capital Mind Premium, I spoke of how the VIX was constructed, and provided a background into Option Pricing. To summarize, one part of the option pricing calculation includes an estimation of volatility in the subsequent days to expiry.
The reason you pay “time value” to options is that there is a risk of the stock being volatile in the time to expiry. Call options suffer the risk of the stock going up beyond the strike price (for the seller of the option, which is a reward for the buyer). The seller prices this risk in the premium demanded for the option. A put seller, accordingly, prices the risk of the stock going down.
The VIX is a glorified average of these implied volatilities, except only on the Nifty, and normalized for 30 days (instead of the number of days to expiry). If you want the details of the calculation, click here. It’s an index that has been disseminated since 2009, and we have a long term chart that looks like the hormonal imbalances of a maturing child.
Currently as low as 13, the VIX is at a trough point, and the lowest it’s been for a while.
Normalization and adjustments
While a regular VIX would suffer from extreme movements close to expiry (since the “time” part of the time value is so little and changing so far), what the NSE does is completely ignore near month contracts 3 days prior to expiry.
For all days prior, the VIX will account for Implied Volatilities on the options of the immediate near month, and the next month. When there’s three days left to expiry, it moves to using the IVs on options of the next month and the month after that (the far month).
Trading the VIX futures contracts
These are large contracts, so if you balk at the size of Rs. 10 lakh contracts or Rs. 1 lakh in premium, please back away from the door right now.
- Quotes: 100 x VIX (gives you four decimal points effectively)
- Lot Size: 750.
- If the VIX is at 20, the quote will be 2000, and per lot of 750 you are exposed to Rs. 15 lakh (1.5 million). This is not a retail trading contract.
- If the VIX moves up from 13 to 14, a single contract will lose Rs. 75,000. (750 x 1 x 100) I’m just making it clear this is a very big contract.
- Expiry, every week on Tuesday, for up to three weeks ahead.
How would you trade them?
People think, wrongly, that the VIX is used to hedge against volatility. It’s not.
The VIX goes down when the market goes up. In general. And the VIX rises when the market falls. In both directions you see volatility, but the VIX gives you no protection. (A true volatility protection product would rise when volatility rises).
The VIX can be used to hedge only the implied volatility part of an options portfolio. Option sellers will have two risks: One, that the asset price moves against them (the stock rises for a call option seller, or a stock falls for a put optopns seller). Two, that the implied volatility increases. In both cases, the call writer will lose. He can hedge out the implied volatility change by using VIX futures. This is useful for index option portfolio, or for a diversified portfolio (but with complex mathematical size adjustments).
(Of course, in reality, if the VIX falls when the stock goes up, then it’s only useful for put option sellers)
You can also use it to remove a contango effect on calendar arbitrage. (Where in a volatility spike, your near-far futures spread could increase because of the volatility expectation increase - you would then benefit from a VIX hedge, where you would be long the VIX future)
But the size is so much that it will not attract retail traders. If you need to trade them, you’d want to learn a lot more about Option vega and options portfolio hedging, than just reading a summary in this blog. (Read this, for instance)