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Using the VIX to Manage Volatility

David Becker
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www.iforex.com

Volatility is referred to past price action as well as potential future price movements determine by implied volatility, which is the key input into option prices. The concept is used as in input into options pricing as well as a methodology to manage risk.

The past 10-years have produced a plethora of exchange traded fund (ETF) which has led to the creation of implied volatility products. Implied volatility ETF’s generally track a specific volatility indices.

Implied Volatility
Implied volatility is the potential theoretical annualized movement of a security in percent format. Implied volatility is the amount traders believe the market will move and is the key input into most option pricing models.

Implied volatility is traded in many formats which include standard vanilla options as well as options structures which combined multiple options. The component of implied volatility is viewed as a market input which fluctuates with sentiment.

Implied volatility is also tracked by exchange traded funds which calculated the at the money strike prices of the S&P 500 index or other benchmarks and produce an index that fluctuates based on this benchmark. The most widely known and traded benchmark for volatility is the VIX volatility index, created by the Chicago Board of Options.

Short-Term VIX ETF’s and ETNs
Short-term VIX ETNS and ETF’s, generally establish long positions in the first and second month VIX contracts on a rolling basis, will often move in tandem with the VIX. S&P 500 VIX Short-Term Futures Index: The index measures the movements of a combination of VIX futures and is designed to track changes in the expectation for VIX over a specific time window in the future
Mid-Term VIX ETNs

These ETNs offer investors the opportunity to invest in contracts that are several months out, as opposed to the first and second month futures that are offered by short-term VIX funds. As a result, mid-term VIX ETNs are generally less sensitive to changes in the spot VIX, but also less vulnerable to the impact of contango in futures markets. The contango is the idea that deferred contracts are higher in price when compared to prompted contracts.

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