Welcome to Futures Industry
Nina Mehta
Published 3/1/2004

At a time when the number of new futures products is higher than ever, it is unusual to find one that elicits as much pre-launch buzz as the volatility products developed by the Chicago Board Options Exchange. In the three years since the Commodity Futures Modernization Act took effect, 478 new products have been introduced, according to the Commodity Futures Trading Commission, versus just 175 in the three years before the CFMA. The fact that so many people in the equity derivatives business are talking about the CBOE’s new line of products suggests that these have a better than average chance of success.

Last August, the CFTC gave its approval to the CBOE to form a futures exchange subsidiary. In late March, this exchange will begin trading its first product, futures on the VIX, a proprietary CBOE index that has become the benchmark for stock market volatility. The VIX, which measures 30-day implied volatility in S&P 500 options, is a “standardized, widely followed volatility index that a lot of people recognize—and one of the few equity indexes on which there are no products today,” says Sandy Rattray, head of U.S. equity derivatives strategy at Goldman Sachs.

The index, introduced in 1993, has earned a reputation as the “investor fear gauge” because its highs and lows measure skittishness in the market and are often perceived as market signals. A high VIX reading means that fear is running high, and that frequently presages a rising stock market. A low VIX is often seen as a harbinger of a declining market.

The CBOE Futures Exchange (CFE) plans to have a designated primary market-maker and a number of market-makers providing liquidity by the time the VIX futures are launched. The contracts will be traded electronically on the CBOEdirect trading platform and cleared by the Options Clearing Corp. The exchange currently has an open membership, with any CBOE member or qualified non-member permitted to trade on the CFE. Membership fees have been waived for the first 12 months. Patrick Fay, a long-time CBOE official who worked briefly for NQLX, the security futures exchange, has been appointed managing director in charge of the futures exchange.

The CBOE has high hopes for VIX futures. “The last time there was such anticipation for a new product was when the CBOE introduced the OEX contract in the early 1980s,” says Joe Levin, vice president for research at the exchange. He notes that this is the first time that investors in the U.S. will be able to trade volatility as a listed product. “Anyone doing volatility plays currently has to buy straddles,” he explains. “There will now be a direct listed investment that isolates volatility.”

Levin sees the universe of potential users as broad and deep. “Hedge funds that use [over-the-counter] volatility and variance swaps are obviously going to be at the forefront of users,” he says. “Also anybody at a firm that has a volatility book, options traders, and dealers in variance swaps.”

Diane Garnick, a managing director and chief U.S. portfolio strategist at Dresdner Kleinwort Wasserstein in New York, is optimistic. “It wouldn’t surprise me if it’s one of the most popular index-level instruments at the CBOE,” she says. One advantage of VIX futures is their transparency. “If a dealer lowers its volatility by two points, the only way for me to know is to compete for the same product,” she says. “Once VIX futures are listed, they will be marked every day and will be available to anybody.”

Volatility has two characteristics that make VIX futures particularly appealing to some investors. It is non-correlated with the broad stock market, and it is mean-reverting. The former means that volatility futures could be used as a portfolio diversification tool by investors, according to Andrew Harmstone, head of quantitative and equity derivatives research at Lehman Brothers in London. “Volatility is more negatively correlated than gold or other products that people put in their portfolios as a hedge,” he says. “As a result you could diversify your portfolio that much better—that’s one of the biggest potential uses of VIX futures.”

The fact that the VIX is a mean-reverting index indicates that when the index reaches high levels, it is likely to come down, and when it is low, it will likely rise. This makes products based on the VIX potentially interesting to statistical arbitrage funds and other relative-value players.

Last September the CBOE made two significant changes to the VIX to make it a more useful underlying index for tradable products. It shifted the index on which the VIX is based from the Standard & Poor’s 100 Index to the S&P 500 Index, which is more widely known and has more than $800 billion in assets indexed to it. This change makes the VIX a more viable index for investors interested in hedging the volatility in their equity portfolios.

The CBOE also altered the methodology for the VIX index calculation. Instead of being based on a weighted average of the implied volatilities of eight at-the-money options on the S&P 100 Index, the new VIX relies on a formula that extracts implied volatilities from a much larger range of options across strike prices. For professionals, this means the VIX utilizes a broader portion of the market’s volatility surface, including the volatility skew. More simply, this means the index reflects a fuller view of expected volatility.

Mark Longo, an options trader and former CBOE member, notes that VIX futures meet a clear and present need. “Volatility is the biggest risk you face as an options trader,” he says. “A trader seeking to profit from options he considers mispriced can hedge volatility with spreads, but there are risks with that. VIX futures allow traders to hedge pure volatility.”

Longo points out that the new VIX is a much better gauge of investor sentiment. Unlike the old VIX, the new VIX takes its values directly from “the S&P 500 options skew—from the ATM options and the put wing and the call wing—so it is closer to a snapshot of the entire month,” he says. “That makes it more viable for traders, since volatility fluctuates depending on the strike you’re looking at.”

It is possible, of course, to trade volatility using options and through OTC volatility swaps and variance swaps. Indeed, interest in the OTC market, which began around 1997, has grown. Dean Curnutt, head of equity derivatives strategy at Banc of America Securities, points out that as the market for variance swaps has matured, there have been more trades, at narrower spreads, and with the ability to execute very large transactions. Users are mainly hedge funds, with occasional insurance companies, endowments and sophisticated pension funds executing trades.

Customers that can trade in the OTC market do so because swaps eliminate the time-consuming and costly need to delta-hedge a portfolio of options. “For the hedge funds that trade variance swaps to use VIX futures would surprise me,” says Curnutt. “In 30 seconds they can call [a dealer] and get a price on a very large trade and have it executed quickly and confidentially.” He adds that the bulk of variance swaps are for a period of six months to two years. Demand for trading one-month volatility is not large.

Leon Gross, a managing director and global head of equity derivatives research at Citigroup, adds that another fundamental drawback in attracting volume from the OTC market is that VIX futures are a play on implied volatility rather than realized volatility.

He doesn’t think the product will appeal to the more-sophisticated hedge funds that trade volatility or variance swaps with Wall Street dealers. Those funds “currently trade implied vs. realized volatility, and anyone who trades the VIX is only trading the implied volatility,” Gross says. “There’s no realized component to it.” Someone who buys a VIX future is thus hoping that the VIX at the contract’s expiry will exceed the VIX at the start of the contract, regardless of how realized volatility behaved. For this reason, he expects VIX futures to be used by retail customers and by macro or fundamental hedge funds.

Another reason some suspect VIX futures may be slow to build traction is that many investors may not understand that volatility has a term structure, which in turn affects the futures price. The volatility term structure reflects the fact that an option’s implied volatility varies across different maturities. As a result, there can be scenarios in which the pricing of the futures differs substantially from the underlying theoretical level of the VIX. If a market crisis occurs and the VIX spikes, for example, the jump in implied volatility will be reflected primarily in short-dated contracts, not long-dated contracts, because the VIX is a mean-reverting index, notes Goldman’s Rattray. At the same time, he adds, “an investor who shorted a VIX future before the implied volatility spiked must recognize that he could face substantial losses.”

Once VIX futures are trading, the CFE plans to list options on the VIX futures, pending regulatory approval, as well as other volatility products, possibly including futures on the square of the VIX. Market participants point out that an obvious candidate is the CBOE Nasdaq Volatility Index, launched last September. “We obviously want to expand the volatility complex,” acknowledges CBOE’s Levin, “but we’re going to do more than just focus on volatility.”

DKW’s Garnick notes that volatility futures based on the Russell 1000 would find a receptive audience among institutional investors. That index is more transparent than the S&P 500 and the amount of money indexed to it is increasing, she says. Another product that has some backers is single-stock variance futures, which currently trade OTC and would be a cheaper alternative to trading listed equity options. For the CBOE, however, one drawback to trading these products would be that they are not proprietary products, like the VIX, so they could be multiple-listed on other exchanges. Citigroup’s Gross also points out that indexes will most likely continue to be the main underlying product for volatility futures, based on demand for volatility and variance swaps over the last half-dozen years.

The VIX futures contract size is $100 times the VXB, or Jumbo CBOE Volatility Index, which is 10 times the VIX index. Until early this year, the futures contract had been sized at $500 times the VIX index. The doubling of the contract size was the result of customer interest, notes CFE’s Fay. This shift suggests that the exchange sees VIX futures as a primarily institutional product, since retail customers typically prefer smaller-size contracts.

VIX futures will be available for the two near serial contract months and two contract months on the February quarterly cycle (February, May, August and November). Futures traditionally have March, June, September and December expiries. The reason for the February quarterly cycle, says Fay, is that a VIX futures contract expiring in May, for example, will settle based on the implied volatilities in the June index options contracts, which will have exactly one month to expiry.

The Fear Gauge:  VIX Levels Since 2000

Source: Lehman Brothers and CBOE

The New VIX Family

VIX   -- CBOE Volatility Index, based on SPX options (options on the S&P 500 index)

VXO -- Old VIX index, based on OEX options (options on the S&P 100 index)

VXB -- Jumbo CBOE Volatility Index (10 times VIX)

VX      VIX futures ($100 times VXB)

A Glossary of Terms

Volatility -- a measure of the fluctuation of the asset return (based on the annualized standard deviation of the asset return)

Standard deviation -- the square root of the variance

Variance -- the average of the squared deviations from the mean

Realized volatility -- a measure of volatility based on the actual behavior of the asset return

Implied volatility -- an estimate of the future volatility of the asset return

Volatility swap -- a forward contract based on the realized volatility of the asset return

Variance swap -- a forward contract based on the realized variance of the asset return

Volatility skew -- the variation of an option’s implied volatility across strike prices

Volatility surface  -- a graphical description of the variation in an option’s implied volatility by strike and maturity

Volatility term structure -- the variation of an option’s implied volatility, at a particular strike, across maturities (a cross-section of a volatility surface at a particular strike)


Nina Mehta is a financial journalist based in New York. She is a former managing editor of Derivatives Strategy magazine and has contributed articles to Institutional Investor magazine.
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