The larger sell-offs in 2022 in both the equity and bond markets have been accompanied by a significant rise in underlying volatility. The most widely followed volatility indicator is the VIX index; often referred to as the “fear index” by investors due to its tendency to spike when the stock market is tumbling. The VIX index is designed to measure the expected, constant 30-day volatility of the US stock market and is calculated using price data from S&P 500 call and put options.
How can the VIX index be used to create uncorrelated investment strategies?
We create five options-based strategies that are directionally neutral and bet on the direction of volatility. The strategies are based on the S&P 500 index and we run a backtest from 2020 onwards. Our pre-built strategy template DynamicOptionStrategy (click here for more information) is used to customise the basket of options to trade on each rebalancing date.
1. Short straddle & short strangle
Both strategies collect premiums from selling a call and put option. The short straddle sells the options at the same expiration at-the-money (ATM), whereas the short strangle uses out-of-the-money (OTM) options. Our strategies sell 1M options, and the strangle strikes the options 3% OTM.
2. Iron condor & iron butterfly
Iron condors are constructed by shorting a vertical put spread and a vertical call spread, and can thus be understood as a short strangle with long options that are purchased further OTM. Our long options are struck at 6% OTM with 1M maturity.
Iron butterflies are similar to iron condors but instead strike the put and call credit spreads so the short put and call are ATM. This results in a higher maximum profit due to the higher premiums received but suffers from a narrower break-even range, i.e. it is more sensitive to larger movements in the underlying asset.
3. Calendar spread
Calendar spreads are used to bet on changes in the volatility term structure of the underlying. It involves buying and selling options on the same underlying and strike price but at different expiration dates.
In our example, we short a 1M put and go long a 3M put, both ATM. This cancels out any intrinsic value if the spread moves in-the-money. Unlike the strategies above, the calendar spread will benefit from an increase in implied volatility.
Trading signal using the VIX
The VIX index is used to construct a trading signal for the five option strategies. The signal is a mean reversion signal that uses the crossover between the 1M and 3M moving average of the VIX index. On crossover, one unit of options is traded within each strategy. In general, the strategies’ maximum profit is limited to the premium received from selling the options. When volatility is spiking (i.e. 1M crosses 3M), the option premiums rise and the strategies remain profitable if the price of the underlying asset (i.e. S&P 500) stays within the implied volatility and the strike ranges.
The graphs below show how the five strategies have performed since the beginning of 2020 and 2022, respectively.
In 2022, the strategies have in general profited from a higher implied volatility environment. Due to their potential higher pay-off, the ‘undefined risk’ straddle and strangle strategies have outperformed the ‘defined risk’ iron condor and iron butterflies strategies. Compared to the other strategies, the calendar spread exhibits a completely different pay-off structure as it benefits from increases in implied volatility.
The performance of the strategies is sensitive to the exact specification of, for example, strike levels. Thus, it is beneficial to run various scenario analyses to measure their robustness.
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