The Chicago Board Options Exchange® (CBOE®) introduced WeeklysSM options on several indexes including the S&P 500® Index (SPX) in 2005 and added popular stocks and exchange traded products starting in 2010. They’ve been a huge success, capturing 27% of the total option volume with 271 million contracts traded in Q1 2015. Within SPX options, the Weeklys options share is even higher—with 34% of the overall volume.
Given the outstanding success of weekly expirations, it’s noteworthy that weekly options on the CBOE Volatility Index® (VIX® Index) didn’t arrive at the Weeklys’ options party until October 8, 2015.
This delay wasn’t due to inattention—the CBOE had to overcome some hurdles before they could be listed. Adding Weeklys options on a security is typically just an economic issue—e.g., will there be enough volume to make it financially interesting to the market makers—but weekly VIX options were a different story.
Practitioners know that VIX options aren’t options on the VIX Index itself. Technically, the underlying for VIX options is a 30-day variance forward priced in annualized volatility, but practically, and for the sake of most of our brains it’s easier and reasonably accurate to view the same month VIX futures as the underlying instrument.
When VIX options and futures expire, typically on a Wednesday, they settle to a price tied to a special VIX calculation that uses transaction prices of SPX options with precisely 30 days remaining until expiration. This expiration price is disseminated with the VRO ticker.
Before Weeklys VIX options could be introduced the CBOE needed:
- Weeklys SPX options expiring around 30 days out with good volume / liquidity
- A VIX calculation that includes SPX Weeklys options (introduced in 2014)
- VIX futures with weekly expirations and good volume / liquidity (introduced in 2015 on the CBOE Futures Exchange)
Having satisfied all these requirements, the CBOE was finally able to introduce VIX Weeklys Options in October 2015—enabling a wide set of option trades with potential advantages over existing alternatives. Market acceptance was immediate, achieving substantial trading volumes almost immediately.
VIX Weeklys options share many features with SPX Weeklys options
Now traders can create weekly volatility option positions with the cash settlement and no-assignment-before-expiration (European style) advantages of SPX Weeklys options. Traders don’t have to worry about short positions unexpectedly being assigned and becoming unwanted equity holdings. Similarly with cash settlement they don’t need to stress about the highly asymmetric outcomes that loom when the strike price of equity settled options approaches the underlying’s price. Absent cash settlement traders are often forced to exit positions that might expire in-the-money rather than risk their options being exercised.
Using VIX options for event style trades
VIX Weeklys options are also a good match to event trades—trading strategies that depend on the timing of an economic event being known (e.g., FOMC minutes release) but not its outcome. When only monthly VIX options were available, it was hit or miss whether they would have suitable expirations dates—now it’s a given. An “IV ramp” event trade would buy VIX calls about a week before the event, selecting strikes from the series expiring a few days after the event—forecasting that the option implied volatility (IV) will ramp-up as the deadline approaches. Typically both the general volatility expectations (reflected in VIX futures prices) and implied volatility of the VIX options will increase as the event approaches. Rather than trying to predict scheduled event outcomes this trade is designed to be closed out near the top of the IV peak that typically precedes an event.
Understanding the underlying
Taking full advantage of VIX options requires a nuanced understanding of VIX futures. Traders know VIX futures converge with the VIX Index coincident with their expiration, but it’s a complicated dance. As expiration approaches there’s often a gap between their values—something has to give. Will the futures move toward the VIX, the VIX towards the futures, or will they meet in the middle?
This convergence process appears chaotic but viewed statistically it follows a mathematically defined path. The ratio of daily VIX percentage changes divided by the daily VIX futures percentage changes follows a natural logarithm of time until expiration relationship.
The chart below shows the pattern:
Data Source: CBOE
The Beta of VIX futures relative to the VIX Index
Until VIX futures approach expiration, they’re sluggish surrogates for the flagship VIX Index. Typically a VIX futures contract with 30 days before expiration only matches 45% of the VIX Index’s daily move. For example if the VIX moves 2% higher, the futures would only go up 0.8%. As expiration approaches tracking gets much tighter, e.g., 75% for a futures contract with 3 days until expiration. This ratio of VIX futures percentage moves divided by the VIX Index’s moves is the beta of VIX futures.
Prior to the advent of VIX Weeklys futures, traders only had one week a month when the beta was 65% or higher. Now there’s always one future / option series available with a week or less of time until expiration—giving traders ongoing access to high-beta futures and options. The curve below gives a close-up on the median betas observed in the last few weeks of trading.
Data Source: CBOE
Bear in mind these are median numbers and the distributions are quite wide, so traders should expect variations in the betas. The historic distribution of betas two days before expiration is shown below.
Data Source: CBOE
Fixed versus variable beta
Volatility Exchange Traded Products (ETPs) like VXX and VIXY don’t exhibit variable beta behavior because they use a mix of the two VIX futures contracts nearest to expiration rolled on a daily basis to provide a constant 30-day maturity. But the cost of that consistency is a beta stuck at around 45%. VIX options with two weeks or less until expiration tend to provide better VIX tracking.
Impact of variable beta on options
The increasing beta of VIX futures as they approach expiration has an interesting effect on VIX options— for most of their lives they don’t decay as rapidly as ETP options.
VIX futures with distant expirations have betas below 0.2—which is reflected in realized volatilities much lower than the VIX Index’s and corresponding lower option IVs. However, as futures approach expiration their beta increases, creating a volatility tailwind that boosts the realized and implied volatilities—which in turn props up option premiums. Near expiration, this volatility boost is overwhelmed by dramatically rising decay factors causing option premiums to collapse.
I ran a Monte Carlo simulation to characterize the impact of this effect on option decay curves. The chart below compares simulated decay curves for At-The-Money VIX options (purple line) vs equivalent ETP Volatility options (blue line).
ETP volatility options show the typical square root of time decay profile, but VIX option decay follows a natural logarithm of time trajectory which has slower decay rates until a few days before expiration.
These VIX option characteristics should intrigue both long and short volatility traders.
Taking Advantage of VIX Option Accelerated Decay
I simulated a trading strategy that can take advantage of this decay profile by selling slightly out-of-the-money VIX calls five days before expiration and holding the position through expiration. I selected the calls’ strike price by rounding up the next to expire VIX futures price to the next available strike (e.g., 15.33 would be rounded to 16). Prudence would insist that the short VIX calls be matched with long VIX calls at a higher strike price to cap the maximum possible loss.
To increase the probability of the short calls expiring worthless, I only executed the trade if the next to expire futures price was at least 3% higher than the VIX Index and the short-term VIX futures term structure was in contango, with the nearest future at least 5% lower than the next month out future.
Using historic VIX and monthly VIX futures data from 2004 on, I determined this trade would have been opened 48 times out of the 138 possible, and would have yielded the maximum profit (full net credit) 83% percent of the time. The eight losing trades had a modest average loss of -0.6 points, and a worst case loss of 1.46 points.
Before the advent of VIX Weeklys options this trade could only be done at most once a month. Now every week presents an opportunity.
Conclusion
VIX options are different. They have odd expiration dates, variable tracking with the VIX Index, unusual decay characteristics, and a different head-spinning underlying for every series. Until recently they were the only options in the top 10 volume lists without weekly expirations.
But now that they’ve arrived at the Weeklys options party, I wouldn’t be surprised to see the slightly eccentric VIX options become the life of the party.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies are available from your broker, by calling 1-888-OPTIONS, or at www.theocc.com. Futures trading is not suitable for all investors, and involves risk of loss. Futures and options on CBOE’s volatility indexes have several unique features that distinguish them from most equity and index options, and investors are strongly encouraged to closely read and understand the ODD and the VIX options FAQ at http://www.cboe.com/micro/vix/vixoptionsfaq.aspx and other informational material before investing. No statement within this article should be construed as a recommendation to buy or sell a security or futures contract or to provide investment advice. CBOE®, Chicago Board Options Exchange®, CBOE Volatility Index® and VIX® are registered trademarks and WeeklysSM is a service mark of Chicago Board Options Exchange, Incorporated (CBOE). S&P® and S&P 500® are registered trademarks of Standard & Poor’s Financial Services, LLC and are licensed for use by CBOE and CBOE Futures Exchange, LLC. Standard & Poor’s does not sponsor, endorse, sell, or promote any S&P index-based investment product and Standard & Poor’s makes no representation regarding the advisability of investing in such products.
