A particularly interesting fact about the Chicago Board Options Exchange’s volatility index — the VIX, which measures the volatility implied by a basket of near-the-money options on the S&P 500 composite index — is that it is negatively correlated to the S&P 500.

Correlations between securities range from -1, representing perfect negative correlation, to +1, representing perfect positive correlation. Currently, the VIX has a -0.78 correlation to the S&P 500 index. In terms of portfolio management, an asset class that has negative correlation with equities can, when introduced into the portfolio, actually reduce overall portfolio volatility and often enhance returns.

Another interesting characteristic about the VIX as an asset class is that it is very volatile. The VIX has a volatility in the 60%-80% range. What that means, in terms of portfolio management, is that one does not need very much of the VIX to offset some of the risks associated with the S&P 500 index.

One other factor that makes the VIX interesting — and at the same time, adds to its complexity — is the fact that the VIX is a range-bound asset class. Volatility can never go to zero, and typically never trades for long periods below 10%.

Similarly, the VIX will never exceed 60% for long periods of time, and will not likely ever trade above 40%. Historically, going back 20 years, the VIX has eclipsed 60% on only six occasions. All of these spikes were caused by major selloffs in the S&P 500 index, and on each occasion, when volatility spiked, it quickly dissipated. The classic example was the October 1987 stock market crash, when volatility spiked above 100% but quickly dissipated to 40% within two days.

As a result of these inherent characteristics, options on the VIX become skewed. For example, the VIX closed at 12.12 — representing 12.12% implied volatility — on Friday, April 7. Typically, we would expect the 12.50 calls and puts to trade at about the same value. The puts would be in the money and the calls would be out of the money.

However, since we know that the VIX is not likely to fall below 10, the price of the VIX 12.50 puts reflect that. So with the VIX May 12.50 calls trading at US$1.50-US$1.60, the puts, despite the fact they are in the money, were trading in the US80¢-US90¢ range.

In keeping with the unique characteristics of the underlying asset, one would expect the VIX to spike should stock prices fall sharply. However, because of the skew that says volatility quickly dissipates, traders will know that when volatility rises to 40%, it will not likely stay there for long. And again, the price of the calls will reflect that.

After a spike

In some cases, after a spike in volatility, calls that are in the money will actually trade for less than their intrinsic value. For example, if the VIX spiked to 40, the intrinsic value of the VIX May 12.50 calls would be US$27.50. However, because of the skewing, the VIX May 12.50 calls might only trade at US$15-US$20. (VIX options are European cash settled, which means that they can only be exercised or assigned on the expiration day and settlement will be made in cash for the difference between the option’s strike price and the closing value of the VIX.)

That brings up the issue of time to expiration as a factor in the price of the option. Again, because of the unique characteristics of this security, a shorter time horizon might actually favour the trader who is long in in-the-money options. The closer to expiry, the more likely in-the-money options will reflect their intrinsic value. Conversely, the longer the time to expiration, the more likely that in-the-money options will trade at a substantial discount to their intrinsic value.

Another point to consider when trading VIX options is that the actual expiry date is not the normal third Friday of the expiration month. For VIX options, based on material provided by the CBOE, expiry is “the Wednesday that is 30 days prior to the third Friday of the calendar month immediately following the expiring month.”

As such, the following expiration dates for VIX options that may be listed through December 2006: May 17, June 21, July 19, Aug. 16, Sept. 20, Oct. 18, Nov. 15 and Dec. 20.

@page_break@In summary, the VIX is an interesting asset class and VIX options are an interesting way to play this asset class. But one must be aware of the asset class’s unique characteristics and the impact those characteristics will have on the way the options are valued. IE