A New Way of Trading Volatility

The CBOE Volatility Index (VIX) measures market expectations of near-term volatility. This is achieved by estimating expected volatility from S&P 500 stock index options in a wide range of strike prices.

The VIX was launched in 1993 and has long been considered the benchmark for measuring market volatility. Over the years, the VIX has undergone some changes but the concept remains the same. It is a real-time view of expected stock market volatility over the next 30-days.

It is often referred to as the “fear index” as market volatility usually rises during times of financial stress, as witnessed recently when credit-market turmoil spread to the stock market. Option prices, and the VIX, tend to rise when the stock market declines. As the stock market stabilizes, option prices, and the VIX decline. This action represents the level of fear investors feel, which tends to rise and fall with the stock market.

As mentioned earlier, the VIX has undergone some changes. The most notable one took place in 2003, and was implemented in 2004.* The VIX methodology was changed, resulting in three important differences:

1. The New VIX is calculated using a wide range of strike prices in order to incorporate information from the volatility skew. The original VIX used only at-the-money options.
2. The New VIX uses a newly developed formula to derive expected volatility directly from the prices of a weighted strip of options. The original VIX extracted implied volatility from an option-pricing model.
3. The New VIX uses options on the S&P 500 Index, which is the primary U.S. stock market benchmark. The original VIX was based on S&P 100 Index (OEX) option prices.

The chart below is the complete closing price history for the VIX, using the new methodology. The chart shows that Friday, August 3, was the highest closing price since the changes were made.

Trading the VIX

On March 26, 2004, the CBOE Futures Exchange (CFE) launched VIX Index futures. Then, on February 24, 2006, the CBOE launched VIX Index options.

Options on VIX will have a multiplier of $100, and will have contract months of two near-term contract months plus one additional month on the February quarterly cycle. Trading hours will be 8:30 a.m. to 3:15 p.m. (Chicago Time). The options will be European-style exercise, and will be cash settled.*

VIX Index options have gone on to become very popular, recently setting a new daily volume record.

Longtime TradingMarkets members and readers will know that we have been using VIX trading strategies for many years. In fact, Larry Connors was among the first traders to publish research on the VIX. This research led to the creation of a number of CVR signals (Connors VIX Reversal), many of which we still use today. TradingMarkets members can access daily CVR signals in the Market Bias section of the stock indicators. This section of the TradingMarkets site is the ideal place to start planning for the upcoming trading day. If you don't have a TradingMarkets subscription, click here to start your 7-day free trial.

This experience gives us, and our customers, a tremendous advantage in building successful VIX trading strategies. We have been trading many of these strategies with real money for more than a decade. The creation of VIX options allows us to expand these strategies and tailor them specifically to focus on trading the VIX itself.

Over the coming weeks we will be publishing a number of new VIX trading strategies. These strategies have never been seen before and have some of the best performance statistics we’ve ever published. We’re very excited about this research and look forward to sharing it with you.

TradingMarkets members can access a number of articles previously published articles by Larry Connors on the VIX in the Learning Center.

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*This information comes directly from the CBOE website.