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Trading the VIX

I'm having a great email conversation with a VIX futures trader that I'd like to share as there are still many misconceptions about the VIX out there-- including from me!

I've harped on this before-- you can't directly trade the VIX; rather, the VIX is a statistic, showing you the supply and demand for SPX options premium. Therefore, it won't have the same price action characteristics than something that is actually tradeable.

The email questioning my thesis is seen below:

Why do you continue to single out the VIX index as not being tradeable?  In fairness, every time you pull up the SPX, DJI, COMP, etc., shouldn't you be stating the same thing?  Just because you can't trade a cash index, the fact that a derivative exists (e.g. VIX futures) effectively means that it is tradeable.

And I responded:

While the SPX and the NDX are not tradeable, you can trade the options. Those options are based on the underlying.

Also, while the VIX is not tradeable, you can trade the options. Those options are not based on the underlying, they are based on a forward price on the VIX futures.

Furthermore, the VIX is a statistic, and the SPX is not. The supply and demand characteristic are completely different. So when people say the VIX is breaking "support," it's meaningless. The VIX futures do not trade off spot VIX, they will converge by expiration, so it's a bet on VIX movement, but not ownership of the VIX itself.

And this is why I don't get invited to dinner parties.

Fortunately, said emailer comes back with some counterpoints that are quite valid:

I willingly defer to you on the correctness regarding your comments about VIX options.  And I now realize that that's the perspective in which your comments about the VIX not being tradeable have likley been intended--you are "IWO" after all.  Add on top of that the divergent price action of the VIX ETN (VXX) and I can see where you're coming from.

But with respect to your comment "The VIX futures do not trade off spot VIX", I actually trade the VIX futures (and ES, NQ, YM, etc.) and I can assure you that the VIX futures trade in the same manner as any other index futures.  The attached chart shows an overlay of the front month futures (line) as compared to the VIX index (candles).  As you can see, when it comes to futures, the VIX price action is unquestionably tradeable.

One thing to note-- I like how I can leverage my IWO brand to make myself appear more right, it's nice to have that when I'm incorrect!

The emailer attached a chart of the VIX futures as compared to the spot VIX-- and the price movement is essentially 1:1. I'll admit, it is possible to trade the SPX volatility using VIX futures-- but with some caveats:

The way VIX futures are set up, they don't trade specifically on the spot VIX-- they can trade higher or lower, depending on the market's expectation of where volatility will be around the VIX expiration for that particular month. For example, the VIX futures are higher compared to the VIX, because investors are expecting higher volatility out in the future.

Right now the VIX is at 19.85, but the November VIX futures are trading at 20.95. They will run in high correlation so you can actually trade the VIX, but it's not pure-- not until expiration comes up, because at some point these two numbers are going to converge.

And then we get to the chicken or the egg problem-- can the VIX futures drive prices in the spot VIX? While I don't think it's the main driver, it certainly can have an effect. If a customer buys to open a huge amount of VIX contracts, the market maker will have to take the other side of that trade. So as to not be hugely exposed to volatility moves, the market maker can then go to the SPX options pit and buy vol out there, which then will influence the premiums and lift the VIX. However, dollar for dollar, I still believe the SPX options premium in and of itself will be the main characteristic of the spot VIX.

So can you buy the VIX? No, but you can get very similar exposure in VIX futures, options, the VXZ-- or you could just buy equity puts, but what's the fun in that?

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/