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CBOE Volatility Index (VIX)

Special Report by Michael K. McCarty, Managing Partner, Differential Research, LLC

July 2013

The recent discussion of Federal Reserve “tapering” has led to a re-examination of various assets by investors and likely started a re-allocation process amongst asset classes. While worldwide equity and debt markets suffering declines, one asset class is rising in value – volatility, an asset class which today possesses an established, vibrant and liquid market in the form of CBOE Volatility Index (VIX) futures.

From trading just a few hundred contracts a day shortly after its initial introduction in 2004, to trading a few hundred thousand contracts a day today, volume and open interest in VIX futures has grown unabated.

(sources: CFE, Differential Research, LLC)

Volume in the series of futures contracts that allow traders and investors to capitalize on movements in volatility expectations has set successive monthly new volume records in each of the first four months of 2013, capped by April’s hat-trick of records: volume for the month of 4,056,760, record average daily volume (ADV) for the month of 184,398 contracts and a new single daily volume record of 449,955 contracts traded on April 15th. While the string may have been interrupted in May, volume in June set another new monthly record of 4,213,488 contracts.  (source: CFE)

So what are VIX futures and what is driving the volume in this unique product?

VIX futures are a series of futures contracts that trade on the CBOE Futures Exchange (CFE) and reflect the market’s estimate for the final 30-days implied volatility derived from a series of S&P 500 (SPX) Index options’ prices. The July VIX future, for example, trades at a price that reflects the markets estimate for the final 30-days expected volatility implied by August S&P 500 Index options’ prices. At VIX future expiration, i.e. the moment exactly 30-days before the subsequent month’s S&P 500 option expiration; 30-day implied volatility for the SPX is determined by applying the VIX calculation methodology, which is outlined in the VIX White Paper.  The calculation is applied to a group of S&P 500 Index options’ opening prices, established utilizing a special opening procedure designed to accommodate the increased volume across a broad range of strike prices that occurs at VIX future expiration.

Essentially, while the price of an equity index reflects the weighted prices of a portfolio of equity securities, a VIX future represents the weighted prices of a portfolio of SPX options.

The history of the growth in volume for VIX futures has reflected the broadening of the trader base over time to include a diverse group including investors, traders, hedgers and market-makers.

At the time of their initial introduction in 2004, VIX futures appealed immediately to traders of existing over-the-counter (OTC) variance and volatility swaps, because the settlement procedure as outlined in the VIX White Paper ( closely resembles the models used to price these types of products. Likewise, market makers and traders who maintain option portfolios or “books” were attracted to VIX futures as a way to hedge their “vega” or volatility exposure. Currently, with nine successive monthly contracts trading, VIX futures allow traders and investors to tailor volatility positions to meet specific timing needs.

(sources: CFE, Differential Research, LLC, Yahoo Finance)

As trading in VIX futures developed, the historical data generated unequivocally demonstrated the negative correlation observed between an asset (such as the equity market represented by the S&P 500 Index) and an asset’s historical volatility extended to that asset’s implied volatility as well (such as the VIX). Consequently, investors seeking to hedge equity volatility or dampen an equity portfolio’s swings increasingly were drawn to the new futures’ products.

(source: Yahoo Finance, Differential Research, LLC)

Initially limited to investors with futures accounts, in 2006 the participation base was broadened with the introduction of VIX Index options, which share the same cash settlement value as VIX futures. Investors with either a futures or options account were now able to trade the VIX.  Through June 13th of this year, average daily volume for VIX Index options traded on the CBOE has been 591,600 contracts daily and exceeded 1 million contracts traded on five separate days. (source: CBOE, Differential Research, LLC)

(sources: CBOE, Differential Research, LLC)

With returns negatively correlated to equity returns and positively correlated to equity correlation, the interest in VIX futures exploded during the financial crisis, as both volatility and correlation increased. The financial crisis firmly established VIX futures as a hedge for an equity portfolio.

The introduction of Exchange Traded Products (ETP’s) in 2009 which promised investors the daily returns of a portfolio of VIX futures further broadened the potential investor base to include any investor with a securities account. Of the approximately 20 ETP’s in existence today whose returns are derived from VIX futures, the net asset value (NAV) of the largest, the I-Path S&P 500 VIX Short-Term Futures ETN (VXX), exceeds $1.2 Billion. (source: I-Path) Further, it was disclosed that, on June 6th, 3.46 million VXX options contracts changed hands, also a new record for that product. (source: Bloomberg LP)

The steady growth in volume, the expansion of the trader base, and the generation of historical price data has also led to increased interest in risk and volatility in academic circles, where published work on the topic has contributed to a better understanding of the asset class, which in a virtuous cycle has further contributed to a broadening interest in volatility products such as VIX futures.

Much like physics, where the effects of Newton’s gravity and Einstein’s relativity are generally well understood while the mathematical equations behind the theory are less broadly understood, today’s volatility traders and most investors have accepted that the VIX calculation likely is the best representation of an asset’s implied volatility, especially as it is readily available from publicly available quote and price data, leading to the application of the VIX methodology beyond the S&P 500 Index to other assets and securities options’ prices to calculate the implied volatility of a diverse group of assets.

So what’s ahead for VIX futures trading?

From my perspective, in the immediate term as the understanding of the relationship between volatility and interest rates is better understood, interest-rate traders and bond portfolio managers will represent the next growth market for VIX futures. The VIX futures’ forward curve’s normal contango shape resembles a yield curve and lends itself naturally to “steepening/flattening” trades, many of which can be executed in the penny-wide VIX futures spreads’ markets.

(sources: CFE, Differential Research, LLC)

However, the common roles of risk and interest rates in the present-value discounting process are likely to gain prominence and attract bond portfolio managers. The massive injection of liquidity into the financial system by the world’s central banks including the Fed over the past several years has both lowered interest rates and suppressed volatility. The reversal or “tapering” of this policy by the central bank could simultaneously raise interest rates and the risk premium or implied volatility. The potential correlation of these two discount factors in a rising volatility market coupled with the financial crisis experience that asset class correlation itself increases with volatility will likely attract investors seeking to hedge asset classes beyond equities with VIX futures.

Understanding this correlation and the extension of trading hours will likely contribute to non-U.S. equity portfolios participation in the liquid VIX markets.

Finally, increased market access and trading speeds will attract shorter-term and news based traders and speculators.


Futures trading is not suitable for all investors, and involves risk of loss.  Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available by calling 1-888-OPTIONS or at CBOE®, CFE®, CBOE Volatility Index® and VIX® are registered trademarks and CBOE Futures Exchange is a service mark of Chicago Board Options Exchange, Incorpo-rated (CBOE). S&P® and S&P 500® are registered trademarks of Standard & Poor’s Financial Services, LLC and have been licensed for use by CBOE and CFE.

About the author:

Michael McCarty is the founding partner of Differential Research, LLC, an independent derivatives research firm whose focus is making the understanding and use of derivatives available for a broader audience.  Mr. McCarty was previously the Chief Equity and Option Strategist at Meridian Equity Partners, where he was best known for pointing out the unusual options activity that preceded exceptional stock price moves in individual equities including Bear Stearns, Fannie Mae and Freddie Mac as well as identifying noteworthy call buying preceding the public announcement of takeovers for companies including Barr Labs and EDS. Mr. McCarty is a frequent guest on Bloomberg TV, Fox Business News and CNBC, in addition to being quoted regularly by the financial press.

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