This Volatility Options Bet Also A Hedge

August 31, 2015

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.

U.S. equity markets have seen historic volatility during the past week, and when that happens, investors turn to the VIX to learn just how much volatility is expected during the next 30 days.

The VIX is a measure of the implied volatility of options on the S&P for the next 30 days. The VIX index measures implied volatility using hundreds of option prices, and since the weighting between the front month and the second month is changing constantly in order to maintain an index with precisely 30 days to expiration, the VIX can’t be replicated.

Price Gap
This inability to replicate the VIX index generates substantial difference between the VIX index value that everyone sees in the media and the price of VIX futures contracts that actually allow exposure to the VIX.

For example, the VIX Index and settlement values for VIX futures as of the close on Thursday:

Futures Contract Expiration Settlement Price
VIX Index 26.1
September 2015 23.95
October 2015 21.5
November 2015 20.68
December 2015 20.08

Since VIX futures are the only way to express an investment point of view, they’re usually the underlying security for VIX ETFs.

Thus, this difference between the VIX index and the price of VIX futures is transmitted to VIX ETFs. That means that VIX ETFs often post surprising results when compared with the VIX index. For example, on Thursday, the VIX index fell by 13.92 percent, while the iPath S&P 500 Short-Term Futures ETN (VXX | B-62) rose by 2.45 percent.

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