10 Things You Need to Know About the VIX

by Jim Woods | June 4, 2010 3:56 am

Take Our VIX Quiz!

If it’s volatility you want, then it’s volatility you’ll get. That’s what the markets have been saying since about mid-April, when the CBOE Volatility Index (VIX) traded below 16. Over the following six weeks, the VIX nearly tripled, soaring past 45 by May 20. Just one week later, the VIX had fallen to 30! Now that’s real volatility, and for options traders, this volatility can be both friend and foe.

But just what is the VIX, what are the issues associated with options trading and volatility, and what are some of the best ways to use the VIX to your advantage If you think you know, or if you’d like to find out, then now’s the time to put yourself to the test with our OptionsZone VIX quiz.

So, if you’re ready, let the volatility begin.

Question 1

True of False: The VIX is an estimation of the 45-day volatility of at-the-money S&P 500 (SPX) index options. The formula is based on the volatility of options in the nearest one or two expiration cycles depending on where we are in the cycle.

Question 2

The VIX is a technical indicator and a security you can trade all in one. It also:

A) Is a gauge of risk and sentiment
B) Can be used effectively by any trader within any market
C) Is nicknamed the “fear index”
D) All of the above
E) None of the above

Question 3

True of False: The VIX is charted like an index, and the lower it goes, the higher traders’ expectations are for short-term market volatility.

Question 4

A rising VIX usually means:

A) Traders have become bearish
B) Traders have become bullish
C) Traders may be shorting the market and trying to limit risk
D) Traders are using bullish strategies and taking on more risk
E) Both A and C
F) Both B and D

Question 5

True of False: The iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX), as a general rule, captures about 50% of the daily move in the VIX. So, if the VIX moves 10% in either direction, VXX will likely move about 5%, in the same direction.

Question 6

The following is true about the VIX:

A) The VIX has become popular to chart just like stocks
B) The VIX is a statistic
C) The VIX has a non-zero low and an unlimited potential high
D) All of the above
E) None of the above

Question 7

True of False: The VIX and the concept of “implied volatility” are closely related.

Question 8

Which of the following is an idiosyncrasy of the VIX?

A) There is a tendency for the VIX to look weaker on Fridays and stronger on Mondays.
B) There is a tendency for the VIX to look stronger on Fridays and weaker on Mondays.
C) Traders tend to lower their bids ahead of weekends and/or holidays to avoid paying for time decay.
D) Traders tend to raise their bids ahead of weekends and/or holidays to take advantage of time decay.
E) Both A and C
F) Both B and D

Question 9

Which of the following is not true regarding options on the VIX?

A) You can buy or sell calls and puts on the VIX, or create spreads, strangles or straddles, just like you can with a stock
B) Because the VIX tends to revert back to the mean, at-the-money calls and puts with the same strike price may have very different premiums.
C) VIX calls and puts expire 90 days prior to the next month’s expiration of S&P 500 index options.
D) VIX calls and puts expire on the Wednesday before or the Wednesday after normal expiration Friday.

Question 10

True or False: Futures contracts on the VIX say nothing of the volatility between now and their expiration. They simply forecast volatility on the specific day they expire.

So, How Did You Do?

Question 1: False – The VIX is an estimation of the 30-day volatility of out-of-the-money S&P 500 index options. However, it is true that the formula is based on the volatility of options in the nearest one or two expiration cycles depending on where we are in the cycle.

Question 2: D – The VIX is a great gauge of risk and sentiment, and it can be used by any trader within virtually any market. The VIX is nicknamed the “fear index,” which is actually somewhat misleading since it doesn’t directly measure fear of any kind. The VIX is actually just a measure of trader’s expectations about volatility in the S&P 500.

Question 3: False – The VIX is charted like an index; however, the higher it goes, the higher traders’ expectations are for short-term market volatility. If option sellers think volatility is going to increase in the near term, they will require larger premiums from option buyers. This increase in option prices is used in the calculation for the VIX index. Conversely, if traders think volatility is going to drop, option sellers will have to reduce premiums to attract buyers. Falling option prices will be reflected in a falling VIX index.

Question 4: E – A rising VIX means that traders are expecting a lot of volatility, and that is generally a bearish sign. That is one of the reasons the VIX is often considered a measure of fear. If investors are concerned that volatility is increasing, the VIX will rise. Conversely, if investors are expecting low volatility, the VIX will drop, and that is considered bullish. So, if the VIX is rising, traders may be shorting the market and trying to limit risk. If the VIX is falling, investors are trading bullish strategies and taking on more risk.

Answers (cont’d)

Question 5: True – As a general rule, the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX), captures about 50% of the daily move in the VIX. Why? It’s mainly because of “mean reversion.” Options traders always anticipate mean reversion from the VIX. That is, what goes up in the very short term will go back down in the modestly longer term. As VXX tracks hypothetical 30-day futures on the VIX, the 30-day future simply tells you where the market expects to see the VIX exactly 30 days from now.

Question 6: E – The VIX can be charted like a stock; however, the VIX differs from stocks in that it is merely a statistic, and it has a non-zero low and an unlimited potential high. Another difference between the VIX and stocks is that the VIX isn’t supply-and-demand driven. Rather, it is a measure of sentiment.

Question 7: True – To begin to understand the VIX, you must grasp the concept of implied volatility. The price of an option derives from an equation involving several fixed variables (strike price, price of the underlying instrument, time until expiration, dividends and interest rates) and one other variable — implied volatility. Implied volatility is a proxy for expectations of future standard deviation. The level of implied volatility gives a window into market sentiment. The higher it goes, the greater the fear level. Every option on every options screen carries its own implied volatility. The VIX takes a very narrow slice of the marketplace and measures the implied volatility of a hypothetical S&P 500 option with 30 days until expiration.

Answers (cont’d)

Question 8: E – One of the quirks of the VIX is that it has a tendency to look weaker on Fridays and stronger on Mondays, even when there has been no real change in the market’s assessment of volatility. This happens because traders tend to lower their bids ahead of weekends and/or holidays to avoid needlessly paying for time decay. This gives the illusion of a drop in volatility, but a better description would be a forwarding of the calendar. Likewise, when traders return from a weekend and/or holiday, the calendar has caught up to the dollar price of the option, giving the illusion of a lift in volatility that is especially pronounced near the open. In reality, though, volatility assumptions stayed the same.

Question 9: C – VIX calls and puts expire 30 days, not 90, prior to the next month’s expiration of S&P 500 index options. Answers A, B and D all are true statements regarding VIX options.

Question 10: True – A VIX future is a bet on where the VIX will be on the day the future expires. That is why you can, and often do, see disparities between the VIX and a given future.

Source URL: https://investorplace.com/2010/06/options-volatility-and-the-vix-quiz/