What's the VVIX, and Why Does It Matter?

Markets are enigmatic, and every tool that can help demystify them is worth monitoring. The good news for option traders? There are plenty of lesser-known trading tools that can help gauge market sentiment and inform hedging or trading strategies.

Consider the Cboe^® VVIX Index. Introduced in 2012 and dubbed "the VIX of the VIX," the VVIX quantifies market participants' uncertainty about future volatility. While most traders are familiar with "the fear gauge," or the Cboe Volatility Index (VIX), which offers a theoretical estimate of the S&P 500^® index's (SPX) future volatility based on SPX options, fewer track the VVIX. However, it can be a useful tool for gauging market sentiment and gaining insights that may inform trades in VIX-linked investment products like VIX options, futures, or exchange-traded funds (ETFs).

Just as VIX pricing is derived from SPX options, the VVIX is calculated based on VIX options. The formula for both—a complex weighting of at-the-money and out-of-the-money options—is fundamentally similar. The specific VVIX reading reflects the market's estimated volatility for a hypothetical VIX futures contract expiring in 30 days.

Essentially, the VVIX is a measure of the market's uncertainty about future volatility.

A low VVIX value suggests market participants believe the VIX will be relatively stable moving forward. Conversely, a high VVIX suggests expectations for greater VIX volatility in the future. This, in turn, can indicate market sentiment for increased volatility in the SPX.

Two key distinctions are worth noting. First, the VVIX tends to be more volatile than the VIX itself. Second, according to the Cboe, the VVIX and the VIX have historically shown low correlation—except during periods of significant market turbulence. Major market shocks, like the onset of COVID-19, have typically led to both high levels of expected SPX volatility (a high VIX) and high levels of uncertainty about that volatility (a high VVIX). While both indexes are sensitive to market fear, as the VIX's moniker suggests, the VVIX only measures the uncertainty surrounding that fear. As a result, these are complementary tools, but not identical, highly correlated, or interchangeable.

It's not possible to trade the VVIX directly because it's an index and not directly linked to any options, futures, or other investment products. But just as the VIX can be used, in part, to consider SPX options-trading strategies, the VVIX can help inform strategy decisions for VIX options.

A low VVIX suggests VIX options may be relatively inexpensive. If a low VVIX coincides with a relatively low VIX, and a trader expects increased market volatility, strategies like a long call or bull call spread on the VIX might be logical considerations after carefully weighing the associated risks.

A high VVIX, conversely, implies relatively high VIX premiums. In this scenario, a bullish VIX trader might explore a short put or bull put spread to capitalize on the higher available premiums. Traders choosing between debit and credit strategies should consider factors beyond relative premiums, including forecasts for options-pricing variables like time decay and implied volatility. It's also crucial to note that certain options strategies—such as selling naked puts on an index or using multi-leg strategies—should only be considered by experienced traders with a great risk tolerance and the necessary level of options approval.

Beyond its role in VIX options strategies, the VVIX serves other key purposes:

• Market sentiment gauge. An elevated or rising VVIX may indicate that option traders are buying protection against VIX price swings, potentially signaling market stress and uncertainty. A lower or declining VVIX could be a sign that option traders are relatively calm, reflecting reduced concern about the potential for sudden increases in market volatility.
• Tail risk barometer. Some traders interpret the VVIX as a measure of demand for hedges against extreme events that spark sudden increases in market volatility. A sharp rise in the VVIX might show that option traders are hedging against tail risks using the VIX. Also called black swans, tail risks are rare and often unexpected events that can lead to rapid and steep market downturns.

Once understood, the VVIX can be a valuable part of a trader's analytical toolbox. While not directly tradable, its ability to reveal one aspect of market participants' sentiment can be incredibly useful for traders looking to hedge portfolios or potentially capitalize on volatility swings.