Futures Option Volatility Trading with the VIX
The adage buy low and sell high was originally used in reference to price, but can also be applied to the practice of trading volatility. In fact, even as a commodity option trader looking to trade market price as opposed to volatility, ignoring measures of potential explosiveness while entering or exiting a market could mean financial peril. While many commodity traders, whether beginner or pro, understand the concept of buying options during times of low volatility and selling them during times of high volatility, emotions often lead a well-planned strategy astray.
Unlike traders that are looking to profit from a directional move in price, volatility traders are more interested in the pace at which the market is moving than the direction. However, I argue that it is important to chart both price and volatility in a commodity market before speculating in options. Doing so provides trades with a better understanding of the 'big picture'.
In my opinion, the most efficient means of trading equity market volatility isn't through the VIX index, or any other similar measure. High levels of leverage, a lack of options on futures market, and a tendency for the index value to erode over time are major factors working against the viability of doing so. Instead, I believe that traders should look to buy or sell options on S&P 500 futures, or more specifically the e-mini S&P (symbol ES). The S&P 500 is a broad based stock index and its value is sharply impacted by market sentiment and the corresponding volatility. Thus, a trader that is of the opinion that volatility will increase may look to buy volatility through the purchase of options written on S&P 500 futures and those looking for volatility to decrease may look to sell volatility buy going short options on the index. Accordingly, insiders often refer to the practice of buying or selling options as "going long volatility" or "going short volatility".
Trading S&P 500 Volatility through Premium Collection in the Futures Market
As mentioned, one way to speculate on variations in volatility is through the practice of option selling, often referred to as premium collection. It is important to realize that I am referring to trading American style options which allow traders to buy, sell or exercise options at any time prior to expiration. This differs from the European style versions that offer far less flexibility. The increased level of flexibility tends to have a positive impact on the value of the option and thus the amount of premium collected for selling it. In other words, option buyers may get more value using European style options (referred to as end-of-month options in the S&P) due to lower premiums; conversely this concept works in favor of option sellers of American style options.
Why Option Selling?
Option sellers are in the business of collecting premium, much like an insurance company, under the assertion that in the long run the 
premium collected should outweigh any potential payouts. This theory is based on the assumption that more options than not expire worthless, which has been suggested by several studies including one conducted by the Chicago Mercantile Exchange. Unfortunately, similar to insurance companies who are sometimes forced to honor their policies on excessive claims, commodity option sellers are vulnerable to monster market moves than can be potentially account threatening. Preventing such disasters ultimately come down to timing of entry along with a good understanding of futures market volatility, market sentiment, and market knowledge. Additionally, experience, instinct and, of course, luck will also come into play. Yet, in my judgment option selling is a superior strategy in the long run.
Futures options selling advocates and equity market volatility traders seem to migrate to the S&P 500 futures market (e-mini S&P). There are other stock index futures such as the e-mini Dow Jones Industrial Average and the e-mini NASDAQ, but the e-mini S&P offers the most liquidity as well as a broader based index with smoother price movement.
CBOE's Volatility Index Futures (VIX)
An important measure of volatility when referring to the S&P 500 is the now infamous Chicago Board Options Exchange's Volatility Index, often simply referred to as the VIX. According to the CBOE, the VIX is a "key measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices" and has become one of the most prominent measures of market sentiment in the world. In “normal” market conditions, the VIX spends a majority of its time below 20. As chaotic price action in the financial markets heat up, the VIX can see spikes into the 30 or 40 levels. However, in historically extreme circumstances such as the 2008 financial crisis, the VIX can trade into the 70s, or even higher.
The VIX futures contract is the sole futures offering on the CBOE exchange. As a result, not all futures brokers offer access to trade it. Additionally, receiving real-time VIX quotes in a futures trading platform isn’t necessarily a given.
The VIX futures market offers contracts expiring each month. The margin to trade VIX futures fluctuates around $3,000 per contract and the point value is $1,000, making it a very volatile holding in any commodity trading portfolio. For instance, fi the VIX moves from 15.00 to 16.00, the trader would have made or lost $1,000 per contract with a margin deposit of just $3,000. If you’ve followed the VIX, you know that it doesn’t take much time to travel a full point. Thus, most traders are probably better suited trading e-mini S&P options, than dabbling with highly levered VIX futures.
Increased values of VIX are highly correlated with higher option premium in the ES (e-mini S&P) options due to inflated expectations of future volatility built into options on futures prices. Assuming he is willing to accept the risk of participating in such a market, times of inflated expectations of volatility, and therefore over-priced options, are ideal conditions for an experienced option seller.
The Quest for Implied Volatility in Futures Options
Unlike the VIX which is derived from the underlying futures price, among other factors, implied volatility is a component of option price. The implied volatility of a futures option, is the amount of volatility implied by the market value, or price, of the option. In other words, the implied volatility is forward looking in that it incorporates the current market precariousness as well as what market participants are expecting at some point in the future.
You may also find that market emotion and sentiment are a component of futures option implied volatility. As long commodity option traders scramble to “buy” volatility through the purchase of options in an attempt to profit from the latest hype, option premiums can and do explode exponentially. As a sidelined options on futures seller, these types of conditions should be inviting. The premise of this approach is to attempt to sell options to buyers that are simply "late to the party". The key is making sure that as a seller you aren't too early.
Selling Puts can be Lucrative, but the Option Strategy Comes with a Hefty Price Tag
It is often the case that selling puts is more lucrative than calls, but the added reward carries baggage in the form of additional risk. Due to the increased levels of risk, timing becomes crucial. By nature an option selling program in the futures markets tend to leave room for error in the execution. Nonetheless, being short puts in a spiraling market can quickly change that.
The phenomenon of put premium in the stock indices being larger than call premium is often referred to as the volatility smile. The volatility smile is a long observed pattern in which at-the-money options have lower implied volatility than out-of-the-money options along with the idea that there is more value in owning a put relative to an equally distant call. This scenario seemed to be born after the crash of 1987 in the U.S.
While there are no crystal balls to let us know when a futures market will turn around and how low that it might go before it does, being aware of historical patterns in price, volatility and market sentiment may help to avoid a compromising situation. Let's take a look at the relationship between the VIX and the S&P.
VIX and the S&P 500
Looking at the chart below, it is obvious that the S&P 500 has been able to forge recoveries during times of spiked volatility as measured by the VIX. Armed with this knowledge, it may be a viable strategy to look at erratic, and many times irrational, trade as a point of entry for put sellers.
Short Put Option Trading Example
For example, based on this assumption put sellers may have fared well during the lows in 2001, 2003 and 2007, and 2011. That is of course assuming that the option seller wasn't early in his entry. If a short volatility trader enters a market prematurely, there is a strong possibility that the trader will be forced out of the market prematurely due to lack of financing or margin. Let's take a look at one of the most opportune times in history to be a volatility seller (sell puts in the S&P).
Beginning in the middle of 2002 and throughout the beginning of 2003, put sellers with savvy timing may have done very well. However, trading is a game of risk and those selling puts during those times were accepting great amounts of risk in order to reap the reward.
Let's take a look at a continuous S&P 500 futures chart during the 2002/2003 lows. While the VIX is a great indication of volatility and extreme market sentiment, it is also helpful to look at indicators of volatility such as standard deviations. Luckily, the creation of Bollinger Bands allows us to visually determine market volatility through the line plot of two standard deviations from its mean. Times of high volatility are denoted by wider bands, or a larger standard deviation, and times of decreasing volatility result in narrowing bands.
As futures market volatility increases, so will option prices. During such times, commodity option buyers are forced to pay extremely high prices for options that in theory are more likely to expire worthless than not. On the other hand, option sellers are provided top dollar for accepting theoretically unlimited risk.
Higher premiums collected not only increase a futures market trader’s profit potential but it also increases the room for error. The money collected for a short option can be viewed as "cushion" in that it defines the amount in which the trader can be wrong and still make money by shifting the reverse break even further from the market. The RBE of a short put is calculated as follows:
RBE = Put Strike Price - Premium Collected + Commissions and Fees
As you can see, the more money that the option seller collects, the deeper-in-the-money the option can be at expiration without resulting in a loss to the trader.
According to the hypothetical data available to us, in July of 2002 with the September futures e-mini S&P price near 780, it may have been possible to sell the August S&P 500 futures 680 put for $4.3 in premium which is equivalent to $215 before commissions and fees (each point in the e-mini S&P is worth $50). If this was the case, a trader could have collected a little over $200 U.S. dollars for an option that was, at the time, approximately 100 points or nearly 13% out-of-the-money.
$215 per contract before transaction costs might not sound like a lot of money, but considering the margin on the trade (required deposit in a trading account) was under $1,000 most traders could have sold them in reasonable multiples. For instance, selling 5 of the August 680 puts might have brought in a little over $1,000 in premium for a margin requirement of less than $5,000. Those that like to calculate return on margin, it would have been roughly 20% had the option seller held the short futures options to expiration a mere four weeks down the road.
*This chart assumes selling a single option in the full-sized S&P futures, which is equivalent to 5 e-mini S&P options. We recommend using the e-mini version of the options due to liquidity and option market transparency benefits.
At expiration, this trade would yield the maximum profit of $1,075 before commissions and fees if the futures price is above 680. Ignoring transaction costs the reverse break even on the trade is at 675.70. This simply means that this particular trade makes money with the e-mini S&P futures price trade anywhere above 675.70 before commissions and fees. Please note that the amount of commission paid will reduce the premium collected and shift the RBE closer to the market. To look at it in another perspective, the trader can be wrong by 104.3 points after entering the trade still manage to break even. If the trader's goal is to put the odds in their favor, this seems to be a commodity option trading strategy to consider.
Selling Options on Futures with the VIX can be an Attractive Trading Strategy
Without regard to transaction costs, futures and options trading is a zero sum game; for every winner there will be a loser. Thus, putting your odds ahead of those of your competition is a must. In my opinion, selling options during times of high volatility, while exercising patience, and incorporating experience, is doing just that.
With that said, where there is reward there is risk; in efficient markets you cannot have one without the other. A short option strategy in the futures markets should only be attempted by those that have ample risk capital to allow for potential drawdowns as well as the ability to manage fear and greed. Fearful traders are vulnerable to panic liquidation at inopportune times in terms of market volatility and option pricing. Likewise, greedy traders are tempted to sell options closer-to-the-money in hopes of higher payouts but the risk may turn out to be unmanageable. I strongly believe that less is actually more when it comes to premium collection. Trade less, collect less, and hopefully enjoy more success.
Commodity Trading 101