Key Takeaways

VIX futures prices can help traders make sense of VIX option prices

The VIX futures term structure, and whether it’s in contango or backwardation, can affect VIX option prices

Learn how to use the VIX Volatility Index (VVIX) to help you choose among option strategies

When the Cboe Volatility Index (“VIX”) was launched 20 years ago, its target was mainly institutional traders and options wonks. Now it’s become the proxy for assessing stock market volatility for all market participants, from the institutional fund managers all the way to the retail crowd.

And for the advanced retail trader set, there are tradable products such as VIX futures (available on the thinkorswim® platform) that can help to further level the playing field between retail and professional traders. With the VIX, VIX options, the VVIX (volatility of the VIX), and now VIX futures, you can increase your market awareness and make more informed trading decisions.

In other words, if you’re fishing for volatility information, and perhaps trading opportunities, there’s a wide net at your disposal.   

The Volatility Food Chain

In a word, SPX options drive the VIX. The VIX (or anticipation of what the VIX might be) drives VIX futures. VIX futures drive VIX options. And VIX options drive the VVIX.

The VIX measures the implied volatility (“vol”) of the S&P 500 Index (SPX) options. The VIX is the market’s collective estimate of how much the price of the S&P 500 might move up or down over the succeeding 30 days. So a VIX at 14.00 should be interpreted as a 14% annualized level of volatility.

The VIX is calculated from the prices of out-of-the-money (OTM) SPX options. So when the prices of SPX options go up, say, because traders expect a larger-than-typical price movement, the VIX goes up. When the prices of SPX options go down, the VIX goes down. The VIX formula takes a weighted average of the first two expiration dates of SPX options to arrive at a hypothetical constant 30-day-to-expiration volatility.

Some investors only watch the VIX relative to the S&P 500. But that’s only half the picture. VIX futures are the other half.

FIGURE 1: VIX futures (/VX) on thinkorswim’s Trade page. For illustrative purposes only.

The symbol for VIX futures is /VX. On the Trade page of thinkorswim, you’ll find the available futures out several months, with different prices at each (see figure 1). When the prices of the further-expiration futures are higher than those of the nearer expiration, that’s called “contango.” When the prices of the further-expiration futures are lower than those of the nearer expiration that’s called “backwardation.” In most financial futures products, contango and backwardation are determined from the “cost of carry”—the cost incurred by owning the underlying stocks or bonds.

VIX futures don’t have a cost to carry. Their contango, or backwardation, is determined by the market’s anticipation of what vol might be. For example, if you’re speculating on the VIX, don’t just look at the VIX index. Look at VIX futures, too. Market uncertainty can create contango in VIX futures where expectation of future market vol exceeds the level of the VIX index.

Back in late 2008, when the VIX spiked higher due to market fear, VIX futures were in backwardation, indicating there might be less vol in coming months. During times of market calm, such as throughout much of 2017 and 2018, contango conditions are seen in VIX futures (see figure 2). 

FIGURE 2: /VX TERM STRUCTURE. In times of relative market calm, contango conditions are frequently seen in VIX futures. For illustrative purposes only. Past performance does not guarantee future results.

Investors may use VIX futures to anticipate higher or lower vol in the near term, and adjust strategies accordingly.

Volatility Fishing Expedition

Retail traders can’t trade the VIX itself, so they often speculate using VIX options. But you can’t look at VIX options alone. When you’re looking at the VIX options on the Trade page, you’ll see expiration dates out roughly six months (figure 3). VIX options are European-style and cash-settled, with Wednesday expiration dates 30 days prior to the third Friday of the calendar month following the expiration of VIX options. (To see the VIX settlement value, use the symbol “VRO.”) It’s confusing, so the expiration dates are clearly labeled for you in the option chain of each series.

Sometimes VIX option prices don’t make sense relative to the VIX. Why? Because of the golden rule of market making—price options off your hedge. As market makers buy and sell options, they hedge trades to avoid directional (delta) risk. If you make markets in VIX options, and you can’t trade the VIX itself, what’s your hedge? Bingo—VIX futures.

That’s why VIX options look at the prices of VIX futures to determine pre-expiration value, not the VIX index. And that’s why the ability to easily view VIX futures is exciting. thinkorswim is one of the few retail trading platforms to offer VIX futures—which helps to make VIX option pricing more transparent. Figure 3 shows you how.

FIGURE 3: BASING VIX OPTIONS OFF FUTURES, NOT THE INDEX. Note the Sep 15-strike puts are priced higher than the equivalent strike expiring a month later. But if the futures term structure is in contango, meaning the September futures are trading below the October futures (See Figure 1), the Sept 15-strike put is deeper in the money than the October 15- strike put. For illustrative purposes only.

With the VIX at 13.22, the 15-strike put with 47 days to expiration was trading for 1.70 (the midpoint between the bid and ask in figure 3) and the 15-strike put with 75 days to expiration was trading for 1.62. Aren’t options at the same strike with more days to expiration supposed to have a higher value than options with fewer days to expiration? Yes, if you’re looking at equity options. VIX options in a particular expiration are priced off the VIX futures with the same expiration. So if you’re looking at October VIX options, those are priced off October VIX futures. And because of the contango or backwardation in VIX futures, the VIX options may look mispriced if all you’re looking at is the spot VIX. (Remember the term structure in figure 2.)

The Interwoven Net of VIX, /VX, VIX Options, and VVIX

Without VIX futures, it’s hard to make sense of VIX option prices. Seeing the price of the VIX futures that have the same expiration as the VIX options, you can tell which VIX options are considered in the money (ITM) and out of the money (OTM). This helps determine the strike prices you choose for VIX option strategies.

Just as SPX drives the VIX, you can plug VIX options into the same formula to get the overall volatility of the VVIX. If the VVIX is low, the market anticipates that vol specifically, and the VIX might not experience large changes up or down in the weeks following. If the VVIX is high, the market anticipates larger VIX price changes. A VVIX chart will frequently show it oscillating up and down, with some mean reversion, like the VIX itself (see figure 4). 

FIGURE 4: VACILLATING VVIX? Note the VVIX, which measures the volatility of the VIX, frequently alternates between high and low. For illustrative purposes only. Past performance does not guarantee future results.

Some traders might use the VVIX as an indicator for future VIX price changes, and/or corresponding price changes in the S&P 500, but you could also use it as a measure of the amount of VIX options premium, and consider whether credit or debit strategies might be preferable. 

Think about the S&P 500. If the S&P 500 has been rallying and pushes the VIX lower, a contrarian trader might believe the VIX is due to bounce. Two bullish strategies to consider might be a short put or a long call vertical spread in VIX options.

Take a look at the VVIX as an indication of whether VIX option premiums are relatively high or low. If the VVIX is high, a bullish VIX strategy might be a short OTM put. If the VVIX is low, a bullish strategy might be a long VIX at-the-money (ATM) call vertical whose debit is relatively low compared to high VVIX markets.

Then look at the /VX futures prices to determine which VIX options are ITM, ATM, or OTM, and choose the strikes for your strategy accordingly (should you decide to proceed).

Overall, this has been a simple example. But it offers basic knowledge of how VIX, VIX futures, VIX options, and VVIX interact, which might make volatility-strategy selection potentially simpler and more straightforward.

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