The CBOE Volatility Index, better known as VIX, is one of the most reliable and commonly used measures of market volatility. It’s calculated using options prices from the S&P 500 index, which helps it track investor sentiment towards future stock market direction. As a result, VIX options have become popular among investors to hedge against market volatility swings. This article will explore VIX options and how they can help you manage risk in your portfolio.

A VIX option is an exchange-traded derivative based on the CBOE Volatility Index (VIX). They are available for trading on major exchanges like the Chicago Board Options Exchange (CBOE). VIX options are similar to regular options in that investors can buy and sell calls and puts on the index. However, there is one key difference; they are cash-settled, meaning that when the option expires, no physical delivery of securities takes place.

How do VIX options work?

VIX options function similarly to equity options, with a few key differences. First, the underlying asset is not a stock or bond but the CBOE Volatility Index itself. That means instead of buying or selling the right to purchase an underlying asset at a strike price on or before the actual expiration date, investors are essentially trading volatility through buying and selling call and put contracts with different strike prices and expiration dates.

Another key difference is that VIX options are cash-settled rather than physically settled. At the expiration date, the option buyer or seller will receive a cash settlement based on the difference between the strike price and the closing index value of the VIX.

Benefits of trading VIX options

VIX options offer investors several advantages over standard equity options. First, since they are based on investor sentiment towards market volatility, they can help investors hedge against potential swings in stock prices. For instance, by buying calls or put contracts with different strike and expiration dates, an investor can protect their portfolio from significant downside moves when markets sell off sharply.

Secondly, because VIX options are cash-settled, there is no need to physically deliver the underlying asset at expiration. It makes them more liquid and more accessible to trade than standard equity options. VIX options are top-rated among investors due to their relatively low cost compared to other derivatives, making them an attractive option for speculators and hedgers.

What are the risks?

VIX options are not without risk. As with any financial instrument, there is a potential loss if investors need to understand and manage their positions correctly. One of the primary risks associated with VIX options is time decay. Time decay occurs when the value of an option decreases as its expiration date approaches due to a decrease in volatility and the underlying asset price remaining stable. It means that if a trader holds an option too long, it may become worthless before they have a chance to realise profits or minimise losses on it.

Another risk faced by traders of VIX options is liquidity risk. Generally speaking, options on futures products are less liquid than standard equity options, meaning these markets may be challenging to enter or exit quickly when needed. Furthermore, since these markets are relatively new and complex, limited resources may be available to gain more knowledge about them.

Investors should also understand their risk tolerance before investing in VIX options. Investors need to consider their objectives and financial situation before deciding what type of vehicle best suits their needs. Furthermore, they should ensure enough capital to cover potential losses before entering any trading position.

What are some other types of options available to UK traders?

Binary Options is one of the most popular options available to UK traders. Binary Options are a type of option where investors speculate on whether the underlying asset will rise or fall in value over a predetermined time frame. Binary option contracts typically offer fixed returns and can be traded with shorter expiry times than traditional options, making them more attractive to short-term traders.

Options contracts are also available in futures and CFDs (Contracts for Difference). Futures are an agreement between two parties to buy, sell or trade an asset at a predetermined future date and price. CFDs provide investors direct access to exchange-traded markets without trading the underlying asset. Like binary options, futures and CFDs are often used by traders who want to take advantage of short-term market movements due to their quick expiry times.

There are also several other more exotic options available in the UK, such as Barrier Options, Ladder Options, Touch/No Touch Options, Pairs Trading and Knock Outs/Knock Ins. UK traders less commonly use these options, but they can still be helpful when hedging portfolios or taking advantage of certain market conditions. When you trade options in the UK, it is crucial to understand the unique features of each type of option and how they can be used in your trading strategy. 

All in all

VIX options offer investors an effective tool to manage risk in volatile markets. They are relatively low-cost compared to other derivatives and can provide potential returns even when the underlying asset price stays stable. Nevertheless, investors must understand the risks associated with these instruments before entering any trading position. Additionally, they should consider all available products before deciding which one best suits their needs. With the proper knowledge and understanding, VIX options can be a powerful tool for portfolio protection or speculation.