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Volatility Index Trading Guide


Introduction
What is Volatility? How is it measured?
Volatility as a Market Indicator
Volatility and options pricing
So why trade the volatility indices?
How to trade volatility through City Index
Want to know more about City Index Volatility Index Trading?


 
Introduction
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This article provides an outline of Volatility Index Trading (VIX). City Index offers VIX through its Spread Betting service – and we will use their VIX service as a model, for illustrative purposes.

We have chosen VIX as our index - an implied volatility index, listed on the Chicago Board Options Exchange. VIX  measures the market's expectations of 30-day volatility on the S&P 500 index - and is quoted continuously during US trading hours.

This market may prove useful for anyone looking to hedge against US equity or option movements - or even to diversify into a completely new market.



What is Volatility? How is it measured? Top

Implied volatility is, strictly speaking, a measure of the rate and magnitude by which a financial variable is expected to fluctuate over a set period of time. It is often used as a measure of market sentiment and the associated risk.

The VIX is a measure of the implied, or expected, volatility of the S&P 500 index over the next 30-day period, using put and call option prices as the basis for the calculations.

The variance is annualised and VIX expresses volatility in percentage points between 0 and 100.

where var = (365/30) x Expected 30-day variance



Volatility as a Market Indicator
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VIX is said to measure market sentiment and to indicate the level of anxiety or complacency within the market.

  • Anxious investors worrying about a potential fall in stock prices will protect themselves by buying lots of defensive put options (giving the right to sell at a predetermined price), to cover their positions in the event of a market fall.

  • Complacent investors relaxed about the steady gains they are seeing in their portfolio are less likely to buy call options (giving the right to buy at a predetermined price) as they are already profiting from their share price gains. Moreover, they are more likely to sell ‘out of the money’ call options against their positions to enhance potential gains. Hence volatility tends to fall in rising markets.

So a more volatile market tends to correlate with a more anxious market sentiment. A low VIX tends to signal a market complacent about current stock prices, buying fewer defensive options. A rising VIX indicates a switch from complacency to a state of anxiety – a state usually caused by a stock market decline.

Many users view the VIX as a contrary indicator. High VIX values such as 40 (likely to be reached when the stock market is very low) can represent irrational fear and can indicate that the market may be getting ready to turn back up. Low VIX values of less than 13 (likely to be reached when the market is very high) can represent complacency and can indicate the market may be at risk of peaking and due for some profit taking.

However, there are no guarantees. The VIX is certainly an interesting indicator to help get a sense of the market, but it should never be relied on without further support.


Volatility and options pricing
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In 1973 Fischer Black & Myron Scholes published a standardised formula for the valuation of options. This model removed the mystery from options pricing and ironed out the inconsistencies that were previously applied by the individual brokerage firms – giving rise to the multi-billion dollar options industry that exists today.

The Black – Scholes formula values an option as a function of 5 key elements:

  • Intrinsic value. The amount by which a stock price exceeds, or sits below, the strike price for a call or put option. This is the most important factor in determining the price of an option.

  • Time value. The amount of time left for the intrinsic value to change, before the option expires.

  • Volatility. The likelihood of the underlying stock fluctuating either up or down. Premiums for options are directly proportional to the expected volatility of the underlying stock.

  • Dividend status. Obviously paying out a dividend will reduce the stock price by the value of the dividend, reducing the call price and increasing the put price.

  • Interest rates. Rising interest rates increase call premiums and decrease put premiums.

Whilst most of these factors can be calculated, volatility is largely an unknown as it reflects market sentiment – or what John Maynard Keynes famously referred to as ‘animal spirits’.



So why trade the volatility indices?
Top


We have seen that volatility is a useful measure of market sentiment and an essential factor in options pricing. So there are several obvious applications for trading the VIX index:

  • As a hedge to eliminate the volatility element of an options trade. If you have bought options on the S&P 500 index, you might feel confident about the intrinsic value, time value, dividend status and interest calculations, but want to remove the volatility element from the equation. Spreadbetting the VIX index is a good method of removing this risk.

  • As a hedge against adverse equity movements. The VIX often holds an inverse position to the underlying S&P 500 index. Positive S&P index movements often result in negative VIX swings. Spreadbetting the VIX index can be used as a hedge against adverse movements in an S&P 500 portfolio.

  • As a stand alone instrument. Many investors use the VIX to trade implied volatility. Spreadbetting the VIX offers cost effective trading in this market.


How to trade volatility through City Index Top

Having established the reasons why you might want to trade the VIX index, let’s examine how you can place a bet through City Index:

  • Priced in £ per point, a bet on the VIX has the same notional trading requirement (NTR) as an S&P options bet (400x stake).
  • The Chicago Board Options Exchange, home of VIX, is open from 2.30 pm until 9.15 pm Monday to Friday.
  • Settlement is against the last traded price and expiry occurs on the Tuesday prior to the third Friday of the month.
  • Trade online or over the phone.
 

Want to know more about City Index? Top

For more information on Volatility Index Trading through City Index, visit www.cityindex.co.uk



 
Barclays
£6.95 / £12.95 – This offer applies to online trades in eq ...

TD Waterhouse
UK - £9.95 flat fee;
Intl - £12.95 flat fee

Internaxx Offshore Broker
UK, Europe, US, Canada - from €19.60
Asia - from €38
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