Options are an essential tool utilized by financial traders to hedge their risks. These instruments, fundamentally the right but not obligation to buy or sell a specific stock at a predetermined price on or before a certain date, give investors control over significant chunks of value despite only paying (and profiting) from small changes in the prices of stocks. Knowing how these tools function is important because it can create opportunities for traders and investors alike.
One such option that has recently come into the limelight is VIX options. The CBOE Volatility Index (VIX) was first introduced to measure market volatility to help estimate future variability in the prices of underlying stocks. It does this by measuring the implied volatility of options for S&P 500 companies with at least $4 stock price and averages the square root of the sum of each individual squared difference between all traded strike prices and the market price. The index is calculated in real-time and can be bought or sold like a stock.
Since VIX futures were introduced in 2004 by the CBOE (Chicago Board Options Exchange), they have been growing in popularity and notoriety for their extreme volatility. What makes these types of options attractive to traders is that they are inherently tied to stocks and indices because they rely on an underlying asset: essentially making them one of the riskiest and potentially profitable instruments available.
Three major constituents of the VIX index
The VIX index has three major constituents, namely the front-month (one month to expiration), second month (two months out) and third month (three months out). Traders typically buy protective puts when they expect a market correction. The activity in buying put options will increase the demand for VIX futures, which like most other commodities, are usually in short supply when prices go up.
For experienced stock traders who usually trade after hours, you can consider trading an overnight future or EOD strategy with VIX options to take advantage of volatility during non-trading hours (“after-hours” trading). You can also use VIX options to hedge your portfolios against sudden price movements in either direction.
Trading strategies available for VIX options
VIX options usually have a 30-day expiration. The VIX index can be traded in both directions – up and down. There are numerous trading strategies available for the VIX spectrum, which include:
Calendar spread strategy
This strategy centres on the idea that volatility has an ebb and flow over time (i.e., like the changing tides). Traders often use this strategy when they feel that volatility will rise again after having fallen recently. They buy near term out-of-the-money (OTM) puts with a low strike price and sell longer-term OTM puts with a higher strike price at or about the same time.
Buy Call strategy
A long call position is taken by buying calls in the hope of profiting from an anticipated rise in the underlying security/index. This can be used when you are expecting high volatility in the market.
Buy Put strategy
A long put position is taken by buying puts in hopes of profiting from an anticipated fall in the underlying security/index. This strategy is considered suitable for traders anticipating a neutral market with low volatility.
It should be noted that volatility futures or Options are not suited for short swings in stock prices because their time to expiration is set based on standard quarterly expirations (March, June, September and December). For any significant changes over shorter periods, it’s better to use plain vanilla futures or ETFs. If you want to trade VIX options, contact a reputable online broker from Saxo Bank, where you can open a free demo account to get started quickly and smoothly on your journey to becoming a master trader at option trading in pakistan.