VIX futures and the VIX options may be an excellent tool for both hedging and speculating on forward volatility. The problem is some trading platforms that have VIX options do not carry a Chicago Futures Exchange data feed. Traders may have access to a great speculative and hedging product in the VIX options, but without a CFE data feed are in a tough position to evaluate any specific option trade. Evaluating a derivative if one doesn’t know the price of its underlying is almost impossible.
If one does not know where that month’s VIX future is trading, picking the right call or put to buy or sell to hedge volatility can be difficult. This may be an even more substantial problem for those that want to speculate on forward volatility. There is nothing worse than buying or selling what a trader thinks is an ATM option only to find out that it is 2 dollars in the money because the trader didn’t know the price of the underlying… or worse, an buying or selling an out of the money option that is really an ITM option. It causes many traders to miss use a product that could and should add rather than detract value from their portfolio.
The good news is there are ways to calculate where a particular VIX future is trading real time, even if one doesn’t have a CFE price feed. The answer lies in what we on the floor used to call combination trades, or ‘combos.’ A combo is a concoction of option trades and carrying cost that when put together can calculate the value of the underlying. It is simply another of the many values of the put-call parity formula: Call-Put=Underlying-Strike Price+ (Interest-Dividends).
Understanding combination prices makes pricing VIX futures easy because:
- The Options are liquid
- Every platform lists VIX options
- The is little carrying cost removing one variable from the combo calculation
Thus, all a trader has to do to figure out that month’s future price is: take the strike price, add the call price, then subtract the put price, or (X+C)-P. Following this approach one can easily see the price that a given months future is trading, even if that trader’s brokerage house makes the mistake of not listing CFE products.
Here is an example using prices as of the close on 3-10-2011:
Closing Price of the April 21 Call: 3.20
April 21 put: 1.55
Combo Future: (21+3.2)-1.55=22.65
Closing price of the Future: 22.68
As you can see, using the combo method we were within .03 of the closing futures price. This should be more than close enough for almost every trader trying to take advantage of the VIX Options.
Trading isn’t easy; the more weapons traders have in their arsenal, the better their odds of success. With this explanation of ‘Combo’s” hopefully, you will be able to better use the VIX options as another weapon in your trading arsenal.
Mark Sebastian is the COO and Director of Education of Option Pit Mentoring, a full service options education program. Prior to founding Option Pit, Mark was a market maker and member of the CBOE. You can read more of Mark’s writing at http://www.optionpit.com/blog