Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange-Traded Notes by Russell Rhoads

Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange-Traded Notes by Russell Rhoads

Chapter 1
Understanding Implied Volatility
In this book, we will discuss the ins and outs of a popular market
indicator, or index, that is based on implied volatility. The indicator is
the CBOE Volatility Index®
, widely known by its ticker symbol, VIX. It
should come as no surprise that a solid understanding of the index must
begin with a solid understanding of what implied volatility is and how it
works.
Implied volatility is ultimately determined by the price of option
contracts. Since option prices are the result of market forces, or
increased levels of buying or selling, implied volatility is determined by
the market. An index based on implied volatility of option prices is
displaying the market's estimation of volatility of the underlying security
in the future.
More advanced option traders who feel they have a solid
understanding of implied volatility may consider moving to Chapter 2.
That chapter introduces the actual method for determining the VIX.
However, as implied volatility is one of the more advanced option
pricing concepts, a quick review before diving into the VIX and
volatility-related trading vehicles would be worthwhile for most traders.
HISTORICAL VERSUS FORWARDLOOKING VOLATILITY
There are two main types of volatility discussed relative to securities
prices. The first is historical volatility, which may be calculated using
recent trading activity for a stock or other security. The historical
volatility of a stock is factual and known. Also, the historical volatility
does not give any indication about the future movement of a stock. The
forward-looking volatility is what is referred to as the implied volatility.
This type of volatility results from the market price of options that trade
on a stock.
The implied volatility component of option prices is the factor that can
give all option traders, novice to expert, the most difficulty. This occurs
because the implied volatility of an option may change while all other
pricing factors impacting the price of an option remain unchanged. This
change may occur as the order flow for options is biased more to buying
or selling. A result of increased buying of options by market participants
is higher implied volatility. Conversely, when there is net selling of
options, the implied volatility indicated by option prices moves lower.
Basically, the nature of order flow dictates the direction of implied
volatility. Again, more option buying increases the option price and the
result is higher implied volatility. Going back to Economics 101,
implied volatility reacts to the supply and demand of the marketplace.
Buying pushes it higher, and selling pushes it lower.
The implied volatility of an option is also considered an indication of
the risk associated with the underlying security. The risk may be thought
of as how much movement may be expected from the underlying stock
over the life of an option. This is not the potential direction of the stock
price move, just the magnitude of the move. Generally, when thinking of
risk, traders think of a stock losing value or the price moving lower.
Using implied volatility as a risk measure results in an estimation of a
price move in either direction. When the market anticipates that a stock
may soon move dramatically, the price of option contracts, both puts and
calls, will move higher.
A common example of a known event in the future that may
dramatically influence the price of a stock is a company's quarterly
earnings report. Four times a year a company will release information to
the investing public in the form of its recent earnings results. This
earnings release may also include statements regarding business
prospects for the company. This information may have a dramatic
impact on the share price. As this price move will also impact option
prices, the option contracts usually react in advance. Due to the

Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange-Traded Notes by Russell Rhoads