Implied Volatility Vehicles

VIX, VXX (VXXB), Term Structure, IV, TVIX: what is all of this?

​With all the talk about VXX, and it being an indicator of future movement, and the VIX "fear gauge", etc., I want to make clear what these "things" are. It is vital to know exactly what you are looking at when you look at these signals and how they are different. 

The first question you might be asking is, "Wiz, why don't you stay in your options lane?" My answer is, all of these are based off of the implied volatility of options. Options pricing is basically comprised of 3 variables and one exponential constant.  Those variables are: the price of the underlying, the price of the option (as measured by supply and demand of the option itself), and interest rates. The exponential constant is time.  We are going to focus on implied volatility (price of the option).

Of all the pricing models out there (BSM, Binomial, etc.), implied volatility is what is solved for at any given time. There is no independent measure of it. Time until expiration (and, therefore, time left) can be measured. You can assume a certain interest rate, and that remains an input to the model. You know what the strike price of an option is, as well as the price of the underlying. You also know the price of the option, the answer to the equation. But using all of those inputs, there are still variations in the price of the option that doesn't make the equation equal. This is showing what the supply and demand is of the option itself due to what the public believes is going to happen in the underlying. This is all boiled into one variable called implied volatility (IV). Further, if you have two different people using two different price models, you will likely get two different IVs! Moreover, it is implying the 1 standard deviation movement, so 2 out of 3 days (close enough), the movement of the underlying is expected to be at or below the implied movement that the IV is indicating.

VIX is a mathematical model trying to boil down all the SPX option IVs into a single number to gauge what the option-buying public is expecting the market to do. VIX attempts to measure the implied volatility of a range of SPX options between 23 and 37 days until expiration in both weekly and monthly option classes. 

VXX (unleveraged), UVXY (1.5x leveraged), and TVIX (2x leveraged) are Exchange-Traded Products (ETPs) that are long volatility. They estimate 30-day volatility by buying a weighted average of the next monthly option expiration and the following monthly option expiration. So today, on January 11th, there is a little bit of January options in the VXX bucket and a lot of February options in the bucket. Every day, more Jans get sold and Febs get bought. February options were lower priced than in January for a long while, but have since gone up in price; hence, we have a situation where the people in charge of VXX are buying more expensive options and selling the cheaper ones (giving a red day on VXX despite the red day in SPX). What VXX is really measuring is the difference in price movement between January and February options, NOT option IV itself. Put into a corner, I'd say it is a so-so approximation of option buyers expectation of volatility.  Since options are typically overpriced and in contango, in the long run, all of these products will decay. But don't get excited to short them; good luck finding a share to borrow.  

Term structure is a weighted average of the options in a single expiry. The weights depend on how it is calculated. Basically, it tells you how much the IV is in that expiration date (again trying to boil it into a single number for each expiration), then draws a chart for all the expirations. This at least gives you an idea of the expectation of the implied volatility differences over terms... a little better than VXX to understand the option-buying public's expectation.  

Finally, what does this all mean for trading?  CNBC calls the VIX the "fear gauge", which I understand how they can assign it that, but it is not really true. Since the CBOE basically dictates the initial prices through their market makers, it doesn't necessarily reflect the public's fear except at extremes. If SPX is plummeting and everyone in the world is buying puts, then yes, it is measuring fear... but on a day like today where SPX is down, but not down enough to justify the IVs the options were at, you can see VIX and SPX going down at the same time. You can see that as a lack of fear... but the more accurate assessment is lack of movement compared to recent history. So hearing anyone calling the VIX the "fear gauge" is like nails on chalkboard to me... trying to boil a complex thing into a polarizing soundbite.  You must also keep in mind that this is only measuring options traders, and option traders have different motivations. Some are hedging, some are speculating, a majority are market makers trying to play spreads between bids and asks on small ticks and orders (most of the option HFT is doing exactly this)... so it is very difficult to read the incentive for moves in implied volatility particularly on slow days.

So ultimately, what does a stock trader do with VIX on their trades?  The answer is absolutely nothing except on big moving days. That is, days that are more than the IV is projecting, and see if the volume is way up or not too far up and see if a crash is imminent.  But that's about it.  If you are an option trader, the VIX is sort of relevant, but there are more important things to account for.  For instance, what is the skew, horizontal and vertical? What is the implied movement vs. the historical movement, are these options overpriced compared to history?  If so, is there a reason? But to be honest, I haven't really looked at the VIX with anything other than a passing glance in quite some time.