VIX Option

A VIX option refers to a derivative contract made on the CBOE Volatility Index (VIX) measuring the anticipated 30-day fluctuation in the S&P 500 index. These options act as a tool for risk management and diversification, allowing traders to hedge against changes in or speculate on market volatility.

They are modeled on European-styled and cash-settled contracts with the option to be exercised only at their date of VIX option expiry. Investors utilize VIX to take profits from increasing volatility as it has negative interrelations with stock market yield and to safeguard investment against market turmoil.

A VIX option is a financial derivative based on the value of VIX. It is a financial tool for traders and investors to speculate on market volatility and manage risk. Such options also enable hedging against market volatility. 

As they are European style, put options can only be executed at the expiration date and not before or after. They are mostly settled in cash, meaning on the ultimate VIX value, allowing traders to gain from increased market volatility. Furthermore, put options fail to offer benefits from volatility, while call options do give traders profits during highly volatile markets.

VIX behaves like a tool to gauge market sentiment, and its higher values represent enhanced uncertainty and fear. Investors usually look towards VIX options amidst turmoil in the market to hedge against possible losses in equity positions. Its liquidity and special characteristics have made it an attractive option to expert investors. 

Regarding influencing the financial world, options of VIX option trading significantly influence risk management practices and trading strategies throughout financial markets. More importantly, they also give deep insights into investor behavior and sentiment, helping in stabilizing portfolios during turbulent market situations. Therefore, options of VIX have been a critical tool in speculating on market volatility and managing risk.

One can find many trading strategies of options of VIX as follows:

1. Hedging Portfolio Risk: It uses the purchases of call options of VIX to protect portfolios from decreasing values.
2. Speculating on Market Volatility: It derives profit from volatility changes by selling/buying VIX put/call options. This can be done by using a VIX option chain that displays all available put or call options at different strike prices and expiry dates.
3. Calendar Spreads: Using a spread strategy, It gives traders profits from term structure variation and time decay.
4. Vertical Spreads: It utilizes options having various strike prices to give profit under a particular range of the VIX index.

Let us use a few examples to understand the topic.

Example #1

An online article published on 30 November 2023 discusses the increased options of VIX. It happened more so because investors have been hedging against market fluctuation between a stock market hike. However, on the other hand, the S&P hand has increased to 18% in 2023, steered by anticipation that the Federal Reserve may pause hikes in rate. As a result, the contract of options of VIX has averaged 760000 every single day, showing a 42% increase from 2022, crossing the past record created in 2017. 

Some traders have used VIX call options to protect their investments against volatility, increasing VIX use by 54% while its put options were enhanced by 24%. At present, VIX stands at 13, lower than its long-term average of 18. Hence, investors have been capitalizing on affordable hedges against possible turmoil in the market. 

Example #2

Let us assume that Zarati, living in Old York City, is an expert trader monitoring the VIX index closely as its value sticks to 22.5. She firmly believes that market fluctuations would only increase because of impending releases of economic data. Zarati decides to buy a 10 VIX call option with a strike price expiry within 30 days at $2.50 per contract using her TechTrade brokerage account.

Her position's total cost is $2000, but after two weeks, some geopolitical drift caused a market selloff, causing the VIX to spike to 28. Hence, Zarati's options have increased to $5 per contract. As a result, she thinks of selling her position for good gains, but finally, she decides to wait until expiry, expecting more volatility in the upcoming weeks.

It has the following benefits for traders/investors:

• The option of VIX can offer portfolio diversification as they perform without having any link with bonds or stocks.
• Acts as the most effective tool for hedging against the volatility of the market, providing protection of portfolio from huge market changes to investors 
• Provides the most unique opportunities for trading as per volatility expectations and market sentiments. As a result, traders can derive good profits from various scenarios of the market.

It also has certain risks like:

• They are sophisticated financial instruments that need detailed comprehension of trading strategies, option pricing and the VIX index.
• Although VIX options are deemed liquid instruments, rapidly changing market conditions can lead to broader spreads of bid-ask, reducing their liquidity.
• VIX option prices are not sensitive to market volatility changes, so that they can result in potential losses due to large swings in price. 
• Just like other financial derivatives, they also contain counterparty risk where the issuer of the contract has the risk of defaulting on their obligations.