Anytime I get a trader asking me about trading the VIX, I usually scare them away by rattling off a lengthy list of complex topics that I suggest they understand before even thinking of dabbling with VIX-related products. It goes something like this:

Do you know what implied volatility is?

Do you understand mean reversion?

Do you know what underlying is for VIX options? Hint – it’s not the VIX Index.

Do you understand how futures contracts work?

Do you understand how to analyze the term structure of VIX futures?

Can you define the words “contango” and “backwardation?”

Do you know how VIX futures and options settle?

If you can’t answer at least half of those, then I highly recommend you steer clear of trading vehicles built around the VIX Index. But not forever! After all, I’m all for trading complex products. It’s mind-stretching, enlightening, and a great way to pass the time. Vehicles based on the VIX require more time and effort to master.

Rather than warning you off and leaving it at that, I decided I’m going the extra mile. I’ve been seeking a new topic for a multi-part series here at the Options Theory blog. And I can’t think of anything more interesting than the VIX. Since I know the answer to every single question posed earlier, I’m happy to share them with you. In the end, you should be well-equipped to dabble as much as you want in VIX options. OR maybe not. Perhaps you’ll discover the complexity isn’t worth it, or that you prefer focusing your efforts elsewhere. That’s okay too. The aim is to help you make a more informed decision.

So, here goes.

VIX What?

The VIX is formally known as the CBOE S&P 500 Volatility Index and charted under the ticker “VIX.” There are many ways to describe what makes it tick. Here are a few of my favorite.

First, it gauges supply and demand for SPX options.

Second, it reflects the cost of insurance. When demand for options rises, their premiums or costs rise. Thus, the VIX rises. Alternatively, when the demand for options falls, their premiums fall. The VIX, in turn, falls.

Third (and most official), the VIX is a weighted estimate of implied volatility for a hypothetical 30-day SPX option.

Fourth, it is an estimate of how volatile the SPX will be over the next 30 days.

The VIX is a multi-purpose vehicle that generates different types of signals. Some use it for strategy selection. When the VIX is low, buying options becomes more attractive. When the VIX is high, short options trades offer better payouts.

Others use the VIX to help forecast market direction. It can sometimes hint that a market bottom is imminent, thus signaling that you should ring the register on bear trades while prepping bull trades.

A final group uses the VIX to tell how much market volatility is expected. You can express this as a percentage such as 16%, 25%, or 32%. Or, perhaps more useful, you can determine the expected daily or weekly movement for the underlying stock.

Like the S&P 500 Index, you can’t actually buy the VIX. There are no underlying shares. But don’t take my word for it. Try it. Input SPX or VIX in the trade tab of ThinkorSwim and click on the ask price to bring up a buy order. This is what it will say:

However, just because you can’t buy and sell VIX directly, doesn’t mean there aren’t ways to game the Index. They list futures contracts on VIX, as well as futures options. But that’s not all! They also have a suite of exchange-traded notes like VXX, UVXY, SVXY (and others!) that are built around VIX futures.

Over time the stable of VIX-based vehicles has grown to include a bounty of products. They all possess their quirks and aren’t near as straightforward as stock. So caveat emptor.

Next time we’ll explore how traders use the VIX as a sentiment gauge. After that, VIX futures and options are coming down the pike. Stay tuned.

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