An Australian VIX option is a type of financial derivative that gives the holder the entitlement, but not the duty, to buy or sell a security at a specified price within a specific timeframe, making them similar to options contracts in other markets.
VIX options are traded on the Chicago Board Options Exchange (CBOE). The CBOE Volatility Index (VIX) measures market turbulence and is often used as a barometer for investor fear.
When should traders use VIX options?
Here is a look at when traders use VIX options.
When the market is about to make a move
Traders should use VIX options when they believe the market is about to make a move but are unsure of the direction. For example, suppose a trader believes that the market is about to experience a period of volatility but is unsure whether it will be due to an increase or decrease in stock prices. In that case, they may buy a VIX call option, which gives them the entitlement to buy shares at a set price within a specific time frame, regardless of whether the market goes up or down.
When you want to hedge your portfolio
Another time VIX options can be helpful is when investors want to hedge their portfolios against market volatility. For example, suppose an investor owns a portfolio of stocks and is worried about a potential market crash. In that case, they may buy a VIX put option, giving them the entitlement to sell their stocks at a set price within a specific time frame, regardless of whether the market goes up or down.
When you want to speculate on market volatility
Finally, traders can also use VIX options to speculate on market volatility. For example, suppose a trader believes that the market is about to experience a period of high volatility. In that case, they may buy a VIX call option, giving them the right to buy shares at a set price within a specific time frame, regardless of whether the market goes up or down.
Risks of trading VIX options
The most significant risk when trading VIX options is volatility. The VIX is a measure of market turbulence and is often referred to as the “fear index.” When volatile markets are volatile, predicting how they will move can be challenging, meaning that VIX options can be risky, particularly for inexperienced traders. But some seasoned traders develop a way to manage risk from a volatile market. Some of them recommend the margin of safety book as a starting point to learn and master risk management.
Another risk to consider when trading VIX options is time decay, an option’s value loss as it approaches its expiration date because its probability decreases as it gets closer to expiry. This risk is amplified in times of low volatility, as there is less chance of the underlying asset moving enough to offset the time decay.
Another risk you must consider when trading VIX options is liquidity because VIX options are not as widely traded as other types of options, such as stock options. It means there may be less liquidity in the market, and it may be more challenging to find a buyer or seller when you want to trade.
How to trade VIX options
Choose your broker
The first step to trading VIX options is to choose a broker that offers them. Not all brokers offer VIX options, so checking before you open an account is essential.
Determine if you want to buy or sell
The next step is to decide whether you want to buy or sell a VIX option. If you think the market is about to experience a period of volatility but are unsure of the direction, you may want to buy a call option. If you’re concerned about a market crash and want to hedge your portfolio, you may want to buy a put option.
Choose your expiration date
Once you decide whether to buy or sell, you must choose an expiration date. VIX options expire 30 days before the third Friday of the month. For example, if the third Friday of the month is June 19, the expiration date for VIX options would be May 20.
Enter your trade
The final step is to enter your trade. You can do this through your broker’s online platform. Once you’ve entered your trade, you’ll need to wait until the expiration date to see if it’s profitable. If the market doesn’t move in the direction you predicted, your option will expire worthlessly, and you’ll lose the premium you paid.