VIX, daily chart as at 10 August 2011

In these uncertain times, you may be tempted to think that the only certainty is elevated feelings of fear, which will have you thinking VIX quicker than the Dow can lose 100 points.

So, buying VIX options or futures must be a ‘sure thing’, that can’t-miss road to instant riches?

Not so fast.

You first need to understand a few basic facts about the VIX, which may be the most ethereal of all tradable instruments.

There is nothing tangible behind the number. It’s not even like an option that confers the right to acquire (or sell) an asset. The VIX is nothing more than the numerical answer to a complicated equation that measures the option premium that traders are willing to pay for out-of-the-money options on the S&P 500. The more they are willing to pay for options, the higher the implied volatility.

So far, so good.

However, just because volatility is spiking right now doesn’t mean it’s expected to remain high. In times of high volatility it’s likely that the VIX goes into backwardation (as opposed to the usual contango). This phenomenon is occasionally seen in the oil market, when a supply interruption causes the spot price to exceed the futures price.

So, high current volatility is not expected to remain that way for months on end. Sure, there is an upward movement in the futures prices (also expressed in the price of options for future expiry), but the extent of the move will be a lot less than the spot VIX.

The only certain thing about VIX is that a dramatic spike will be temporary, which makes one think that possibly the only way of trading the VIX profitably is to trade it at its extremes, perhaps by using current month options.

However, the VIX remains a very, very dangerous instrument to trade, and is probably best left as an object of curiosity.

Warren Buffet famously described derivatives as “financial weapons of mass destruction”. At the top of the heap – so toxic one could refer to them as “Those Which Shall Not Be Named” – are trades structured around VIX options.

Let me give you an example. A ‘calendar’ involves options from two different months. So, with the VIX above 40 (yesterday’s close was 42.99), let’s say a trader sells August call options with a strike of 47.50 (six days to expiry) and buys the September expiry (41 days away) of the same call. Because of backwardation there may even be a small credit, let’s say 10c (that’s $10 per options contract).

Sweet, the trader thinks, I’m getting free money. Let’s really scale this, by buying 100 contracts. So the trader gets $1000 into his trading account.

The hope is that at expiry (six days hence), VIX is below 47.50, so the short call option expires worthless. Let’s say the trader can now sell the September calls for $1, which equates to $10,000 for the 100 contracts. Beautiful.

However, if the markets get really messy and VIX spikes to 70, the trader is on the hook for 22.50 (the difference between 70 and the strike price). The problem is that – due to backwardation – the September calls may be worth a lot less than that. So, the trader has a liability of $2,250 times 100 contracts; a cool $225 000. Let’s say that the September calls are trading at $15, so he’s only got $150,000 coming in. He casually entered a trade that gave him a $1000 credit (hoping to make $10,000), but he now owes his broker $75,000.

Now that is a weapon of pretty serious financial mass destruction.