What do the $VIX,
$SPX (S&P 500),
$NDX (Nasdaq 100),
$RUT (Russell 2000),
and the $DJX (Dow Jones Industrial Average) all have in common?
Besides the fact that you hear about them all the time…
They are all cash settled indexes!
Throughout this article, we will explain what a cash settled index is and exactly how you can buy them (hint: you can’t buy them with stock!).
What Is a Cash Settled Index?
When we speak about “cash settled” what exactly does it mean?
In order to find out what it means we need to understand what the word “settled” means by itself.
Let’s use an example…
I go out and buy one call option in $AAPL because I heard the new iPhone 7 has some cool new wireless headphones.
And I believe that $AAPL will trade higher.
So I buy a call because I heard that’s what you can do if you think a stock is going higher.
Fortunately for me, when my option expired, $AAPL’s stock price was higher than the strike price of my call.
I bought the $105 call and $AAPL finished at $106.
In the scenario above, you would purchase 100 shares of $AAPL stock at $105 a share…
Meaning you purchased $AAPL one dollar below the current price…
But in this scenario, like 99.99% of the stocks out there, $AAPL’s options settle to stock.
Let’s figure out what this is by using all of the underlying we have mentioned to far in this past ($VIX, $SPX, $NDX, $RUT, $DJX, $AAPL).
Here is our friend $AAPL. Traded yesterday (9/9/2016) with over 46 million shares. The second most liquid underlying in the world besides the $SPY (S&P 500 Index ETF).
And what’s the big difference between all of these and $AAPL?
They have no volume…
And with no volume means…
You cannot trade stock in these securities, or as we like to call them…
And since there is no stock to buy or sell, the options cannot settle to stock…
So what do they do?
They settle to cash.
In the $AAPL example above, if it was a cash settled security, you should receive $100 in your brokerage account after settlement rather than 100 shares of stock.
But I’d Like to Buy 100 Shares of the $VIX?
It is a cash settled index thus has no stock to buy.
But there are plenty of ways to get the synthetic equivalent of buying $VIX.
What are my options?
$VXX and $UVXY?
I know! I can buy
$VXX (Barclays Bank iPath S&P 500 VIX Short Term)
$UVXY! (Proshares Ultra VIX Short Term Futures ETF)
Yes, the short answer is that you can buy them all you want.
In fact, they themselves have a ton of liquidity.
But do you want to?
With $VXX and $UVXY being based off the VIX futures (/VX), they, unfortunately, have a negative drag against them 80% of the time.
So while you can buy then, you should not…ever.
Please refer to the link above for a thorough explanation.
What Can I Do?
The good news is if you want to get long the $VIX, you can!
And no, that doesn’t count buying the $VXX or $UVXY which have negative drag against them.
Fortunately, we have already hinted at it in another blog post 🙂
You can “buy” $VIX to get long volatility synthetically many many ways.
What are you talking about?
And how delta, amongst many things, is the synthetic equivalent of stock.
In the follow video, we explain how an options delta is it’s stock equivalent:
Again, if we buy a call with 11 deltas, we are synthetically long 11 shares of stock, or in this case, 11 shares of $AAPL.
So then all we need to do to buy our 100 shares of the $VIX is to get to 100 deltas right?
One of the ways we can get synthetically long 100 shares of the $VIX is to buy synthetic long stock. This can occur by selling an at the money (50 delta) put while at the same time buying the at the money call.
As you can see here, we purchased the 16 call (61 delta) and sold the 16 put (41 delta). This gives us the synthetic equivalent of long 101.86 shares of $VIX (if you could buy stock)
And to do this it costs you $190 or the $1.90 debit and our break even is $17.90.
Remember, the goal is to get to 100 deltas, and we can also doing that by selling two at the money puts.
Let’s see how we can do this…
You can see here we sold two 17 puts and now have 102.27 deltas. For this trade, our break-even is $15.20.
Short Put Spread
In a short put spread, we sell a put, then buy a put further out of the money to define our risk. Let’s see how we can get 100 deltas doing this:
In this trade, we are selling the 17 put and buying the 15 put. And we are doing each 17/15 put spread 5 times in order to get 106.68 deltas.
In this example, our break-even is $16 and our max loss is only $1 ($100 per spread).
Long Call Spread
Let’s see how we can get to 100 deltas via a long call spread:
In our long call spread, we have bought the 17 call and sold the 19 call to cap our upside. We had to do this trade ten times in order to get to 96.91 deltas.
The break-even on this trade is $17.65.
Wrapping Up Cash Settled Indexes
Now you know how you can substitute options to get the stock equivalent for cash settled indexes…
Or any stock in the world.
After reading this article you know that there are plenty of ways to get synthetically long 100 shares of stock:
- Synthetic Long
- Short Put
- Short Put Spread
- Long Call Spread
Each of these trades can be done at any time to replace 100 shares of stock.
Add this to your list your list of things you used to not know…