What is the VIX, and How Do VIX Options Work?

If you’ve spent any time looking at financial markets, chances are you’ve come across the VIX, also known as the “Volatility IndeX” or the “Fear Gauge.” But what is it, exactly? And how do VIX options work? We’re going to take a look at the absolute cluster**** of volatility, options, and futures to get a solid grasp of what on earth is going on. I’m going to attempt to keep things simple though that’s a tall order give the fact that people literally write dissertations on this stuff. But hey, let’s give it a go anyway!.

The VIX: The Measure of Market Mood Swings

At its core, the VIX is a measure of expected volatility in the S&P 500 index. It’s like a weather forecast for the stock market—if the VIX is high, the forecast is stormy, meaning traders expect big price swings. If the VIX is low, it’s a calm, sunny day, meaning traders expect the market to move in a more stable, predictable manner.

The VIX is calculated based on the price of options on the S&P 500. Specifically, it looks at the price of options that are about 30 days from expiration. When options traders are willing to pay higher premiums for protection against potential market drops, it signals that they expect more volatility, which pushes the VIX higher. Another metaphor: If everyone is suddenly scared of a global pandemic, the price of preventative medicine should go up, according to supply and demand. Instead, there’s a run on toilet paper. Go figure.

The Vol Futures: The Underlying of VIX Options

So, now we know the VIX measures volatility, but how do VIX options come into play? Well, VIX options give you the right to buy or sell the VIX itself. …except that’s not possible because there are no shares of the VIX, it’s just a calculation.

So, what do those options give the holder rights on?

The underlying asset for VIX options isn’t the VIX index itself but rather volatility futures (symbol /VX).

Ok, so what ARE volatility futures?

Vol futures (that’s what the cool kids call ‘em) are contracts that let you speculate on the future value of the VIX index. They are standardized agreements to buy or sell the VIX (which isn’t actually possible) at a future date at a predetermined price. The futures contract expires at the current value of the VIX (mostly/sort of). Futures contracts are used by traders who want to bet on where volatility will be in the near future. For example, if you believe that volatility will rise after a major political event or economic report, you might buy Vol futures to profit from the expected spike.

Think of vol futures as a bet on future volatility. But instead of betting on stocks or commodities like gold, you’re betting on how crazy the market will get in the future.

Contango and Backwardation: The Dance of Volatility Futures

Now, let’s talk about two key concepts that affect vol futures—and, by extension, VIX options: contango and backwardation.

• Contango: This is when the price of longer-dated vol futures is higher than the price of shorter-dated futures. In simple terms, traders expect volatility to increase in the future, so they’re willing to pay more for longer-dated futures. Contango is common in the vol futures market, especially when the market is calm, and traders expect volatility to rise down the road.
• Backwardation: This is the opposite. It happens when the price of shorter-dated vol futures is higher than the price of longer-dated futures. This signals that traders expect a big spike in volatility in the near term. Backwardation can happen after a major news event, like a geopolitical crisis, when everyone thinks volatility will spike soon but then taper off.

These concepts have a huge impact on VIX options because they determine the direction of the futures curve and, therefore, how the options will behave.

How Major News Events Impact the Vol Futures Curve

Now let’s think about how major news events influence the VIX and its futures curve (the visual representation of the various futures contract expirations). If there’s a major news event—say, a surprise interest rate hike, an unexpected election result, or a natural disaster—this can cause a massive spike in market uncertainty, and as a result, the VIX can jump.

Here’s where it gets interesting: A news event can cause the futures curve to shift from a normal contango (where future volatility is priced higher) to backwardation (where short-term volatility is priced higher). This shift happens because the market anticipates a short-term surge in volatility due to the news, and traders rush to buy short-term protection, bidding up the vol futures. As a result, VIX options, which are based on vol futures, can experience sharp price movements as well.

Big black swan event or major, major potential news event = backwardation
Normal market = contango

VIX Options: How They Work in Basic Terms

VIX options are essentially options on the vol futures, which means they give you the right (but not the obligation) to buy or sell those futures at a certain price at a certain time. If you’re familiar with stock options, the concept is similar—but with volatility futures instead of stock shares.

• Call Options on VIX Futures: A call option gives you the right to buy vol futures at a specific price (called the “strike price”) before a certain date. If you think volatility is going to increase, you might buy a call option on the vol futures. If the futures rises above the strike price, you can profit from the increase in volatility.
• Put Options on VIX Futures: A put option gives you the right to sell vol futures at a specific price. If you think volatility is going to decrease, you might buy a put option on the vol futures. If the futures contract falls below the strike price, you can profit from the decrease in volatility.

VIX options let you trade based on how you think volatility will behave, but you’re trading options on the /VX futures (vol futures), NOT the VIX itself. If you want to actually trade the VIX itself, well, you’ll need to buy truckloads of options on the SPX. : )

Wrapping up

Understanding the VIX and VIX options is a must for traders who want to bet on—or hedge against—market volatility. At the heart of it all is the relationship between the VIX, vol futures, and the volatility curve. The VIX gives you a snapshot of expected volatility, while vol futures let you speculate on future changes in volatility. Major news events can cause sudden shifts in the futures curve, moving the VIX (and VIX options) in unpredictable ways.

If you’re a n00b, think of VIX options as a way to make a wager on how much the market is going to freak out in the future. If you’re right, you could profit. If you’re wrong…

And as a general rule, never, ever, ever be naked short volatility. Read up on XIV if you’d like to know why.

Trade safely!