Investors Beware -- The VIX Options Are a Lie

These are strong words, I know. I wouldn’t choose them if I weren’t truly concerned, because apparently not many care about the thousands of investors who have been burnt using volatility index (VIX) options and the VXX, a VIX-based ETF product, to invest in volatility.

Before I get into why these investments are completely wrong for the average investor, I need to offer balance to that statement and hopefully prevent many of my former colleagues at the CBOE from removing me from their Facebook friend list (or worse).

There is a place and a function for the VIX, VXX and the options that trade on both. To some extent, they are related to volatility and can be reactive and utilized in some form or fashion. Unfortunately, the behavior of both products even leaves me frustrated (and I have been trading options for 15 years).

What the Bold Print Giveth, the Fine Print Taketh Away

Last week, Robert Whaley, who created the VIX back in 1993, was on CNBC discussing his new Alpha indexes (I will examine those at a later date). Earlier that day he talked about the VIX and said it was an accurate “fear” indicator.

I disagree!

He is obviously a bright, talented mathematician and educator, but probably sees the world a bit differently than the average investor. He also has an intimate relationship with the products that he creates, which may indicate a lack of objectivity.

Aside from the fact that mathematical models can’t mimic real life and that theory and application are two very different things, I am more concerned with the opinion he offered in the interview and the lack of caution to investors in these types of complex products.

He joked that he made 30% yesterday (in his new product) and implied that trading regular “vanilla” options are more dangerous and complex than the Alpha indexes he recently helped create. (I’ll take that argument any day.)

While I am sure these unique products perhaps will have a place in the portfolios of professional derivatives traders, the home-gamers (most of us) out there need to do their homework and exercise extreme caution. There are sometimes dangerous nuances and abnormal behavioral characteristics to these products that should be fully understood before you invest a single penny.

The VIX and VXX are perfect examples of too much hype, too little understanding and a gaggle of fine print.

What the Heck Is the VIX?

The VIX is a NON-TRADABLE index that measures the implied volatility of all of the options in the front month(s) expiration cycles of the SPX to create an (expected) 30-day volatility of the S&P 500 index. It uses a complex formula that basically finds the “average” volatility of those options and generates a number (the VIX spot price).

The number that is generated is actually an annualized percentage rate. More specifically, it is supposed to be a measurement (one standard deviation) of what the option markets are anticipating in terms of volatility for the next 30 days.

But a VIX measurement of 16 doesn’t mean the options are pricing in 16% volatility for the next 30 days. To find one monthly standard deviation, you must divide the VIX buy the square root of the number of months in a year (3.46).

(By the way, if you don’t understand what the heck I just said, you have no business trading the VIX.)

Confused Yet? It Gets Worse…

VIX (and implied volatility in general) tend to have an inverse relationship to the value of the S&P (or any stock or index for that matter). When stocks drop, volatility (measured by the VIX) tends to rise and vice versa. So that effect in and of itself can be confusing.

Then there is the fact that the masses call the VIX the “fear” index, so that when the VIX is high, you might say the (stock) market is scared, perhaps oversold. When it is low, they you might say that the market is complacent and it may be a good time to exit your long (stock) positions.

So when do you buy and sell the VIX options or the market? Before you even worry about finding the best option to buy or sell, you have to determine what is cheap and what is expensive (this is easier said than done in the VIX). Again, many professional traders have analytical tools, complex strategies and mathematicians hard at work trying to find “value” in the VIX.

Most of us simply don’t have the resources or knowledge to trade it effectively.

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)

VIX Options Are NOT Based on the VIX Value

So after all that, there is yet another layer of confusion. Being that you can’t actually buy the VIX itself, traders might buy calls when they think the VIX is going to rise and puts when they feel it might fall… But guess what…

THE VIX OPTIONS ARE NOT EVEN TIED TO THE “SPOT” VIX PRICE!

Yes, you are reading that right. The VIX options derive their value from the VIX futures, which may be much higher or lower than where the VIX is actually trading.

Example:

The figure below lists all the calls and puts offered for the VIX. It’s called an option chain. Looking at the option chain, let’s say you think volatility is going to rise, so you buy the VIX June 18 call for $2.95. It’s circled in blue below.

View larger chart

You may think the VIX is $15.77 (yellow highlight at the top of the figure), but in actuality the options are priced based on the future value of $19.57 (red highlight at the top of the outlined column). So tomorrow, if the stated value of the VIX goes up to 18, but the future drops to $18.50, you will actually LOSE money!

I can’t tell you how many traders (retail and professionals) have fallen into this trap. In fact, just Friday, a friend of mine bought the June 17 calls and lost money today when the VIX was up almost 8%!

Just look at how EVERY call option was down (orange highlighted column) today, with the VIX up $1.08 — That would not happen under normal circumstances.

VXX

I have also found that frustrated investors may choose to invest their dollars in the VXX instead of the VIX, seeking a volatility trade. VXX can be bought and sold like a stock, but it has its share of nuances as well.

Because the VXX is NOT based on the VIX, but on front-month futures in the VIX, the VIX could be up and the VXX might be down or vice versa (this was happening yesterday); it is all very confusing and sometimes frustrating for many investors.

Above is a snapshot of yesterday’s net change in both; look how the VIX is up 7% and the VXX is down 2% (yellow highlights). Would you be frustrated??

Lastly, I wanted to show you how the VXX (red line) has performed compared to the VIX (green line) and let you judge the relationship between those two indexes. You tell me if they are strongly correlated to one another. Do you notice that the VXX has dropped 70%, while the VIX is about where it was about a year ago? The VXX is generally not a good long-term volatility investment.

View larger chart

Please, just exercise caution and learn these products if you intend to trade them. They are not as straightforward as they seem, and may end up going against you unless you fully understand exactly what you’re trading. Don’t be afraid to ask the help of a derivatives expert!

*Editor’s Note: We hope Jared’s article has primed you for his upcoming special appearance on CNBC’s Fast Money tomorrow, April 27, at 5:00 pm ET, where he’s going to dig into the VIX, earnings and more. Don’t miss it! Oh, and when Jared said he’d take his options strategies over those of VIX creator Robert Whaley, he meant it. Check out how Jared uses options to truly reduce risk and make reliable gains.

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