Customized Volatility: A VIX For Everyone

If you think the world is VIX-y now, just wait, it’s about to get VIX-ier. This, from the CBOE.

The Chicago Board Options Exchange (CBOE) today announced that it has filed for Securities and Exchange Commission (SEC) approval to list options based on recently-created volatility indexes that track individual stocks —Apple (AAPL), Amazon (AMZN), Goldman Sachs (GS), Google (GOOG), and IBM (IBM) — using CBOE’s widely-followed CBOE Volatility Index (VIX) methodology.

“Stock VIXes,” first introduced in January as volatility benchmarks, have allowed investors to track individual stock volatility with a quantifiable measurement for the first time.  Pending regulatory approval, investors will have the ability to trade options contracts based on the volatility component of the individual stock.

The VIX reflects traders’ expectations for future volatility on S&P 500 index options. The CBOE also announced that it will “apply its proprietary CBOE Volatility Index® (VIX®) methodology to options on six highly-active, sector-specific exchange-traded funds.”

Younger me would have considered this all beyond ridiculous. You don’t need to “VIX” a set of options to determine an implied volatility. Many trading systems and services like iVolatility or LiveVol provide actual implied volatility.

You also don’t need to trade options on a stock or fund’s volatility when you can trade actual, liquid options on all of the above. Here’s a dirty little options secret: When you trade options on AAPL or IBM or anything, you have actually placed a bet on the underlying volatility of any of the above.

Buy hey, I would have said all that about VIX futures and VIX futures options and VXX and VXZ and all the other VIX offshoots. And yet they have certainly caught on to say the least. VIX options and VXX itself each set single-day volume records the week after the Japanese earthquake. So it seems that the trading public may be comfortable with the oddities of these products.

But individual stock volatility contracts figure to have a boatload of quirks above and beyond index volatility quirks. Consider AAPL before an earnings release. Actual implied volatility in AAPL options will often soar, but an option on Apple’s volatility itself may not – especially if it expires beyond the earnings release date.

That’s because the implied volatility on AAPL (and many other stocks) often gets pumped up ahead of earnings and then drops back to “normal” after the news. An option just on the implied volatility of a stock is a bet on the IV level at a specific future date, when the volatility option expires.

But an actual option on AAPL itself estimates the realized volatility in AAPL stock between now and whenever the option itself expires. On the other hand, an AAPL volatility option will simply snapshot AAPL implied volatility on the day the contract expires. So while a regular VIX contract may provide an overall market hedge, an “Apple VIX” or “Goldman Sachs VIX” may not hedge against news-related moves in the underlying stock.

I do welcome the introduction of these new VIX-es. Whether you love or loathe VIX methodology, it has become an established standard for measuring volatility. Applying it to everything under the sun does give us consistently measured volatility data, in a very user-friendly format. I would just urge extreme caution and lots of homework before you actually start trading one of these vehicles.

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While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

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