How to trade VIX options in England?

The VIX is a tradable index that tracks the expected volatility of the S&P 500 over the next 30 days. 

It is often called “the fear index”. If you’re familiar with futures, then it might be easier for you to imagine this as an equity market implied volatility future – like buying or selling VFX (volatility futures.)

But if there’s an upcoming event in the US and investors expect it to be negative, they would sell these same equities/buy puts. 

The net result is lower prices on the SPY/VOO/UVXY and higher prices on the puts.

Since the VIX is just based on how much people are willing to pay for or sell volatility. It’s not affected by whether things are up or down – only by the magnitude at which traders are willing to trade. 

Variance swaps

That being said, despite its name, it’s a measure of demand for multi-month variance swaps – this is what you’re trading when you buy or sell an option contract – not the VIX itself.

Variable swaps have become popular has nothing to do with directional price movements. 

These products were pioneered in part by Paul Wilmott (the namesake behind Wilmott magazine.) 

He used them to simulate the behaviour of a variety of exotic options with unfavourable payoffs for sellers. 

It made them attractive because they could be priced with an arbitrage-free formula. 

Since variance swaps have no up-front cost, just a small fee for every day held in them, it was much easier to set up a simulation over a long period. 

Then compare it with a closed-ended option you were thinking about buying or selling to see if it was priced moderately.

These products were popularised from 2007-to 2009 by Johnathan Wilmot’s Volcube trading platform. Perhaps the most notable use unrelated to simulations was during October 2008 when Goldman Sachs started writing/taking liquidity on SPXPM (the S&P 500 variance swap that tracks the VIX.) 

It allowed them to profit from the elevated level of volatility during that month.

Exchange-traded products (ETP)

Since then, there have also been ETPs (exchange-traded products) that track the VIX index. 

These are typically structured as 1x leveraged long funds – like UVXY and TVIZ, or inverse funds – like XIV and SVXY (jokes aside about whether you can call something “inverse” if it multiplies the daily return by x2 instead of x-1.) 

The most significant difference with these compared to variance swaps is that they rebalance their underlying holdings every day based on the changes in their benchmark index. 

Sometimes this isn’t a big deal, but when things get volatile, it means that you’re forced to buy or sell the instruments which underlie these funds every day – and this can be very costly if it’s not anticipated.

The VIX options trade differently than either of these products traded at a different exchange (CBOE.) 

Comparing styles

They’re European style and expire every quarter. It means that you settle them through cash, not through an exchange of shares. 

Since the settlement is done with cash, they are more expensive than futures contracts – because there’s an up-front premium for the privilege of holding these things until expiration. 

Also, since they’re American style – this means that you can sell them any time up until the end-of-business on Friday and still get their total value. 

Taxing

The biggest downside with these options is that there’s no way to trade them in a tax-deferred account. 

Even though they’re settled through cash – not physical delivery like other equity options (SPXPM, SPYPM etc…) 

Also, if you want to trade them and then rebalance your position by selling your calls and buying your puts every quarter. 

Because of changes in your outlook for volatility over various time frames – this would be considered “constructive sale” under IRS rules. 

The constructive sale means that any gains on those option positions (or theoretically even unrealized losses) will get taxed as ordinary earnings, which can be up to 39%.

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