During the last few years, there have been a number of new products that have moved to the forefront.  One of these products is options on the VIX Index, where is a gauge of the implied volatility of a certain at the money options. Known sometimes as the fear index, the VIX tends to increase in value as certain markets move lower, triggering fear for most investors.

During the collapse of the equity markets during last 2008 and into 2009, the VIX surged as the equity markets declined.  The negative correlation, nearly 94%, is an excellent gauge of how the markets are performing.

There are a number of volatility indices. The VIX is the leader in terms of recognition, but the NASDAQ and Oil are also tracked.

Some believe that the VIX is a confirming or coincident indicator, and point to specific incidence that make connection  tenuous.  During a specific period of the  financial meltdown from late 2008 to early 2009 when the equity markets continued to plunge while the VIX dropped dramatically.   One could also look at this period as a precursor to an up move, where the VIX was foretelling an up move, that started in March of 2009.

The VIX as a Hedging Instrument

The VIX as portfolio hedge Historical volatility is the underlying market’s actual fluctuation over a defined period. Implied volatility is the market’s estimated future volatility and is reflected in options premiums  the higher the expected volatility, the higher the premium.

The relationship the VIX and the implied volatility of an underlying instrument can be calculated by deviding the VIX by 16.  For example, if the VIX where trading 32, then implied volatility would be 2%, which is the expected change in the underlying instrument daily.

One of the most common ways to hedge and gain upside exposure to the VIX is to buy call options.   In this situation, and investor would be concerned that the underlying markets could move lower, and to hedge their exposure, they would purchase calls on the VIX.  Since purchasing options give you additional leverage, the amount of premium on a relative basis is low.  To reduce the expense of the options, an investor could also purchase a call spread on the VIX, or buy a collar on the VIX.

A collar is a trade in which an investors purchases a call option and simultaneously sells a put option.  If the premium of the call equaled the premium of the puts, the cost of the structure to an investor would be zero.  A call spread is an option where investors buys a call with one strike and simultaneously sells a call option with a higher strike.  The call option purchased will normally have a premium that is more than the call that is sold at a higher strike.  This structure will cost less than a standard call options, but will limit the upside to the difference between the strike prices of the call options.

Liquidity in VIX options has increased substantially during the past 18 months. Not only has average daily volume nearly doubled since November 2008, but the size of a given trade that can be priced reasonably without disrupting the market also has grown. Early in 2008, a 5,000- contract trade was considered large. Now, trades of 50,000 or even 100,000 contracts are more common. These large trades attract more players (banks, hedge funds, etc.) to the market. More players will undoubtedly mean tighter markets, which will allow you to trade positions cheaper than before.  Additionally, many retail players have entered the volatility markets.

One way for an investor to follow the movement of the VIX and overlay a technical indicator to determine if it is rich or cheap is the use Bollinger Bands.  Bollinger Bands are a technical instrument that measures the X standard deviation of a time series around a Y moving average.  In this case, this is a 20-day moving average and 2 standard deviations.  When the VIx moves to the low end of the Bollinger Bands and crosses it or touches it, it is a good time to buy a call on the VIX to protect your portfolio.