Sleuth Readers Speak on Volatility
Sep 19th, 2006 | By Penny Sleuth Contributor | Category: Investing Strategies, MacroeconomicsHello again, Sleuths,
As I mentioned in recent Technical Tuesday columns, my essays on volatility and the VIX index have generated quite a bit of interest. On August 22, I addressed a comment and question from one Sleuther regarding his experience trading the VIX option. Since then, we have received other correspondence. So, I thought I would use today’s column to comment on three more e-mails on this stimulating subject.
As I’ve said before, my purpose in writing this Technical Tuesday column is to bring to your attention some of the myriad ways to employ technical analysis to improve your trading or investment results. One way I’ve tried to do this is by describing some of my favorite technical indicators. At other times, I’ve used some of those indicators to analyze one or two broad-based market indexes. I’ve also written about seasonal market patterns, sector relative strength, and volatility. In each article, I’ve tried to discuss issues I thought would be of value to you.
However, I do not presume to know exactly what’s on your mind. But if you take the time to shoot us an e-mail, I figure that what you’re writing about is probably important to a number of other Sleuthers as well. So, for those of you who have e-mailed us, thanks for writing in.
Now, here are some more e-mails on volatility, along with my comments. I hope you find these enlightening. Let’s start with an easy one:
Q: “Do not understand ‘VIX.’ Please explain. Thanks.”
A: VIX stands for the Chicago Board Options Exchange Volatility Index. It is a measurement of the expected volatility (up-and-down movement) over the next 30 days in the S&P 500 Index. The VIX Index is constructed from near-the-money puts and calls on the S&P 500 Index in the two months closest to expiration. For more information on the VIX Index, take a look at my earlier Sleuth columns on the subject:
Q: “Dear Mark,
“I have to agree with the Sleuther about the value of the VIX options. In May I bought the 12.50 Nov. calls for my own account and the VIX. Subsequently spiked to the low 20’s. The intrinsic value was $8.00+, however the best ask price was around $4.00. Annoyed at the poor pricing, I sold that position and just watch the VIX as a measure of general market complacency.”
A: The Sleuther is referring to the e-mail I wrote about in my August 22 Sleuth article. If you missed that issue, or would like a refresher, you can use the link above.
As I said on August 22, my primary purpose in discussing the VIX Index was not so much to furnish you with a pure volatility trading play. Rather, I wanted you to have at your disposal a widely followed volatility metric to use as an additional technical indicator to make better trading and investment decisions. I, like the Sleuther in the above e-mail, typically monitor the VIX to gauge the overall level of fear or complacency in the market at any particular time, in light of the S&P 500’s recent price behavior. But as I have pointed out previously, do not underestimate the VIX’s ability to forecast, or at least confirm, market turning points.
Nevertheless, as a trader I understand that sometimes you have a strong conviction about something other than the direction of a stock, ETF, or market index. And if you have a strong conviction about volatility, you want the opportunity to capture a profit if your forecast is accurate. So, I understand the annoyance the Sleuther experienced in trading the VIX option.
The problem this Sleuther faced was in buying a VIX option with six months until maturity. The VIX Index is based upon options with an average of 30 days until expiration. Although the VIX is constantly updated, options with six months until expiration are not in synch with the time frame underlying the Index. That divergence in timeframes, plus the added guesswork involved in attempting to project volatility levels into the distant future, is what probably caused those options to fail to attract sufficient trading interest. A lack of trading interest results in a lack of liquidity and poor option pricing.
The bottom line is if you are interested in making a pure play on volatility, the simplest way is to trade VIX options closer to expiration with a large amount of open interest. You can also trade the VIX futures or create a strategy combining VIX futures and options. Otherwise, just use the VIX index as another technical tool. Don’t worry, it’s a good one.
Q: “I traded the VIX options based on Strategic Investment’s recommendation. When the options did not move directly with the VIX price ($12 in the money trading for half that) I researched and found out that they are European options so they do not move directly with the price unless you are in the near month. Dan Amoss recommended selling them once I brought this question up. I have kept my calls since I am looking for a higher VIX this fall.
“I could have traded even the farther out options a couple of times for profit rather than hold them but not near the profit the actual VIX price reflected.
“It appears that you need to either trade close months on a short term basis or buy longer term trying to anticipate when a market bottom might occur (for calls).
“As an example the 25.5 calls for Sep went from $3.50 at the beginning of August to $1.60 this week, while the Feb 07 12.5 calls stayed between $4.30 and $4.70. The Sep 15 puts went from $1.20 to $2.15 while the Feb 07 15 puts stayed between $1.80 and $2.00.
“I don’t understand why they would issue European style options but they did.”
A: Given the way longer-dated VIX options are priced, it’s not advisable to trade in and out of them. Due to the inefficient way they’re priced, over the long run the spreads between the bid and ask will just kill you. If you have a strong conviction about the long-term trend in volatility, you can buy a longer-dated VIX option. Just be prepared to hold it until close to expiration when the option will be much more liquid and be priced better.
If you don’t want to put all your eggs in one basket, or if you want to hedge yourself, you can trade around a longer-term VIX option with shorter-term ones. Or, as I said earlier, you could employ a strategy combining VIX options and VIX futures. But if you follow this last approach, you might first wish to consult a knowledgeable broker.
It’s true that VIX options are “European style,” meaning they can only be exercised on the settlement date. By contrast, most stock, ETF, and index options are “American style” options, meaning they can be exercised prior to settlement.
I contacted the Chicago Board Options Exchange (CBOE) to find out why VIX options trade European style. I was told since the VIX option price is based upon the price of the VIX futures (it’s one-tenth the value), limiting the opportunity to exercise the options until settlement makes it easier to settle the options, especially when there is a spike in volatility. I was also told the VIX option premiums would be more expensive if they traded American style.
One last reason the VIX options trade European-style is for purposes of consistency. Keep in mind the price of the VIX Index is based on options on the S&P 500 Index. Those S&P 500 Index options also trade European style.
There is also one last point to consider. An in-the-money VIX option may not fully reflect its intrinsic value, when measured against the current price of the VIX, because the price of the option is based upon the VIX futures contract, rather than the VIX Index.
Thanks for your questions and comments on the VIX. If you have more queries on this subject, just e-mail us at thesleuth@agorafinancial.com. Although I can’t respond directly to you, I may just include your thoughts in a future Technical Tuesday column. And if I don’t know the answer to your question, or want to get a further take on the point you raise, I might go to the horse’s mouth and get the answer from the CBOE.
In my next article, I’ll discuss another measure of volatility. I hope you enjoyed this one.
Trade well,
Mark Bail
September 19, 2006
The Penny Sleuth, presented by Agora Financial, features articles on penny stocks, options, small-cap stocks, pink sheet stocks and OTCBB coverage.
Sign-up for the FREE Penny Sleuth e-letter to get small-cap stock analysis and options strategies sent straight to your email inbox every trading day.
We Value Your Privacy
