Question

Write short essay explaining how the valuation of the CBOE Volatility Index is influenced by market uncertainty. Offer a strategy for investing in call options on the CBOE Volatility Index based on expectations of changes in market uncertainty.

Answer 1

CBOE Volatility Index & the influence of market uncertainty on its valuation

The Chicago Board Options Exchange (CBOE) created the VIX (CBOE Volatility Index) to measure the 30-day expected volatility of the US stock market, sometimes called the “fear index”. It is a real-time market index that represents the market's expectation of 30-day forward-looking volatility & hence, provides a measure of market risk and investors' sentiments. .
The VIX is based on the prices of options on the S&P 500 Index and is calculated by aggregating weighted prices of the index’s call and put options over a wide range of strike prices.
Investors, research analysts and portfolio managers look to VIX values as a way to measure market risk, fear and stress before they take investment decisions.

Volatility measures the frequency and magnitude of price movements over time. The more rapid and substantial the price changes, the greater the volatility. It can be measured with historical values or expected future prices. The VIX is a measure of expected future volatility.
The VIX is created to be used as an indicator of market uncertainty, as reflected by the level of volatility. The index is forward-looking since it seeks to predict variability of future market price action.

The fact that VIX represents expected volatility is very important. It is based on the premiums that investors are willing to pay for the right to buy or sell a stock, rather than being a direct measure of volatility. The premiums for options can be seen as representing the perceived level of risk in the market. The greater the risk, the more people are willing to pay for “insurance” in the form of options. When premiums on options decline, so does the VIX. If people are too optimistic or fearful, there is a good chance that the market will behave erratically. When the VIX gets higher, there is more fear.

For example, suppose an investor looking to buy stocks. If the VIX is high, he knows that there is likely to be more volatility in the market. This could indicate that rapid changes in stock prices are coming soon, potentially leading to buying opportunities.

Market Volatility can be measured using two different methods. First is based on performing statistical calculations on the historical prices over a specific time period. This process involves computing various statistical numbers, like mean (average), variance and finally the standard deviation on the historical price data sets. The resulting value of standard deviation is a measure of risk or volatility. Since it is based on past prices, the resulting figure is called “realized volatility” or "historical volatility (HV)."
The second method to measure volatility involves deriving its value as implied by option prices. Options are derivative instruments whose price depends upon the probability of a particular stock’s current price moving enough to reach a particular level (called the strike price or exercise price). For example, say IBM stock is currently trading at a price of $151 per share. There is a call option on IBM with a strike price of $160 and has one month to expiry. The price of such a call option will depend upon the market perceived probability of IBM stock price moving from current level of $151 to above the strike price of $160 within the one month remaining to expiry.
Since the possibility of such price moves happening within the given time frame are represented by the volatility factor, various option pricing methods (like Black Scholes model) include volatility as an input parameter. Since option prices are available in the open market, they can be used to derive the volatility of the underlying security (IBM stock in this case). Such volatility, as inferred from market prices, is called forward looking “implied volatility (IV).”
In investment management, volatility is an indicator of how big (or small) a stock price moves, how a sector-specific index, or a market-level index changes over time, and it represents how much risk is associated with the particular security, sector or market. For example, S&P 500 index offers an insight into volatility of the larger market.
The VIX Index is the first benchmark index introduced by the CBOE to measure the market’s expectation of future volatility.

VIX Volatility Index Graph (Source : Yahoo Finance)

The VIX is given as a percentage, representing the expected movement range over the next year for the S&P 500, at a 68% confidence interval. In the above graph, the volatility index is quoted at 13.77%. It means that the annualized upward or downward change of the S&P 500 is expected to be no more than 13.77% within the next year, with a 68% probability.

The VIX Index is a volatility index comprised of options rather than stocks, with the price of each option reflecting the market’s expectation of future volatility. Like conventional indexes, the VIX Index calculation employs rules for selecting component options and a formula to calculate index values.
The components of the VIX Index are put and call options with more than 23 days and less than 37 days to expiration. These include SPX options with “standard” 3rd Friday expiration dates and “weekly” SPX options that expire every Friday, except the 3rd Friday of each month.

The monthly, weekly, or daily expected volatility can be calculated from the annual expected volatility. There are 12 months, 52 weeks, or 252 trading days in a year. By using the annual expected volatility of 13.77% from above, the calculations are as follows:

Expected Volatility (Monthly) :-

%

Expected Volatility (Weekly) :-

%

Expected Volatility (Yearly) :-

%

A high VIX indicates high expected volatility and a low VIX number indicates low expected volatility.

When investors anticipate large upswings or downswings in stock prices, they often hedge their positions with options. Those who own call or put options are only willing to sell them if they receive a sufficiently large premium. An aggregate increase in option prices (which indicates greater market uncertainty and higher projected volatility), will raise the VIX and, thereby, indicate to investors the probability of increasing volatility in the market.

The VIX is considered a reliable reflection of option prices and likely future volatility in the S&P 500 Index.

The long-term average for the VIX volatility index is 18.47% (as of 2018). In the current times of Coronavirus Pandemic, although central bankers and governments around the globe had responded with policy initiatives, and equity markets had rebounded somewhat. But the VIX was still as high as 66% in the end of March. The current VIX index level as of April, 2020 is 41.04.

Statistically speaking, a VIX below 20% reflects a healthy and relatively moderate-risk market. However, if the volatility index is extremely low, it may imply a bearish view of the market.
A VIX of greater than 20% signifies increasing uncertainty and fear in the market and implies a higher-risk environment. During the 2008 Financial Crisis, the volatility index wnt to extreme levels of above 50%. That meant that option traders expected stock prices to fluctuate widely, between a 50% upswing or downswing within the next year, 68% of the time. At one point during the crisis, the index reached as high as 85%.
Although VIX levels can be very high during times of crisis, extreme levels are rarely sustained for extended periods of time. This is because the market conditions lead traders to take actions to reduce their risk exposure (such as purchasing or selling options). That, in turn, reduces the levels of fear and uncertainty in the market.

A strategy for investing in call options on the CBOE Volatility Index based on expectations of changes in market uncertainty

As markets have been plunging over the last few months and insecurity is high, it's good to take a look at volatility indices. They are great trading tools in a down-turning market. VIX is the ticker for the CBOE Volatility Index, which measures implied volatility of S&P 500 index options. Currently, the VIX is the most commonly used method of measuring expected volatility.VIX-Linked Products Make It Possible to Gain Directly From VIX Movements.
Call and put VIX options are both available. The call options hedge portfolios against a sudden market decline.

There are several options to trade the VIX. The one simplest approach is to buy Exchange Traded Notes (ETN) or Exchange Traded Funds (ETF) on the index. For example, the largest vehicle is the iPath S&P 500 VIX Short-Term Futures ETN (VXX) & the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). These are two based VIX based futures.

However, an investor who wants to make money investing in the VIX doesn't have to trade it directly. Another strategy is to buy put options during times of low volatility. This way, investors make a bet that markets are overbought and will turn bearish soon.
On the contrary, if the VIX is high, an investor may buy ETFs/ call options that track the S&P 500. Once the VIX is above 30, investors are panicking and selling their stocks based on fear. That leads to quickly falling stock prices. If the VIX starts to decline, it's a good time for investors to place their buy. In general, if volatility declines, stock prices will increase.

Long Call Strategy

If a trader forecasts a rise in expected market volatility, then buying a VIX call option might be an appropriate strategy. Any option trade involves a minimum two-part forecast. The first part is the direction of the underlying instrument, and the second part is a forecast for the time period of the expected price move. When trading VIX options, there may be third piece to this forecast i.e the VIX value.
Since VIX options are priced using the same assumptions as the corresponding VIX futures contracts, it is often helpful to check the price level of that corresponding VIX futures contract.
Lets assume that the VIX index is currently 16.50 and a trader forecasts that December VIX index settlement to be approximately 20.00. Based on this forecast, it might seem reasonable to buy a December VIX call.

The most fundamental principle of investing is buying low and selling high, and trading options work on silmilar startegy. So option traders will typically sell (or write) options when implied volatility is high because this is similar to selling or “going short” on volatility. Likewise, when implied volatility is low, options traders will buy options or “go long” on volatility.