The Chicago Board Options Exchange Volatility Index uses the market ticker symbol VIX. It is a measure of the expected volatility in the market for the S&P 500 index options over the next 30 days. A high VIX spot reading may be seen as a harbinger of a major market move, either to the upside or the downside. Although the number reports the expected market move in the 30 day period, its reading is annualized. So if the VIX reading is 40, then it is predicting a 40% change in the market over the next year, up or down. The actual change in the next 30 days will be less. The VIX numbers are calculated and reported in real time while the United States markets are open.
A VIX option is essentially a bet on what the VIX reading will be at the expiration of its 30 day contract period.
Differences Between VIX and Stock Options
There are three primary differences between VIX options and stock options:
- VIX options are European-style options. Thus, they can only be exercised on the day they expire.
- VIX options expire on a Wednesday instead of a Friday.
- VIX options require cash settlement, as there is no physical product to take possession of when the option is exercised.
The Relationship Between VIX Option Prices and Current VIX Readings
The spot reading of the VIX index at any given moment is not likely to track the VIX option, because the VIX option is based on the expected VIX reading on the day it expires, which is the only day the option may be exercised. As the expiration date approaches, the spot and the option value of VIX will tend to converge.
The VIX Options Is Mean Reverting
The VIX option is considered to be a mean reverting value. The concept of mean reversion is that high and low prices are aberrations. A given value will tend to stay at or around its average over periods of time. For investors, this means that if the current price of an investment is less than its long-term average, it is a good buy. If it is higher than that average, it might be a candidate for profit-taking or seen as a predictor of a coming downward move of the market. Looking at the VIX option, which is a bet on the value of the VIX statistic at the end of its contract period, gives traders ideas about where the market will going on that day.
