Kudos to Adam at Daily Options Report for today’s A Quick Trading VIX Primer, which provides a succinct explanation of the basis for VIX options prices – some of which have left casual options traders scratching their heads in recent days.

In Adam’s words:

“The VIX estimates volatility on the SPX itself for the next 30 days.

VIX futures are a bet on where that estimate will be on the day the future expires. In other words, it is a snapshot of what the market expects for volatility 30 days AFTER the future expires. If it is a September future for example, you are guessing how the market prices volatility 30 days forward from September expiration. You are not betting on SPX volatility between now and September; that is a common misconception.”

Two graphics might help to illustrate this point. The first graphic initially appeared on VIX and More one year ago in VIX Futures: The One Picture to Remember and shows what happened to the VIX futures on the day before and the day of the record 64% spike on the VIX on February 27^th 2007. The bottom line is that the long-term outlook for volatility did not change appreciably, but the VIX futures moved from contango (upward sloping over time) to backwardation (downward sloping over time). So the future still looked the same, but the VIX was expected to take a different path to arrive at essentially the same place.

The second graphic is a snapshot of the VIX options as of this morning. Note that with the (cash/spot) VIX at 17.24, the bid on the May 17.00 puts (0.15) is almost the same as the bid on the May 22.50 calls (0.10). The reason? Mean reversion is priced into the VIX futures – and the options reflect the consensus opinion that a 5 point VIX spike is just about as likely as a 0.25 point drop in the VIX over the next week (recall that VIX options expire on Wednesdays; this month it is one week from today.)