CBOE Futures Exchange
December 31, 2012 Volume 6 Issue 12


A CFE Newsletter focused on Volatility Futures

Welcome to a new year!

2012 was a great year for the CBOE Futures Exchange. New volume and open interest records were broke and new products were launched.
In 2013 we will continue to provide you with updates and new information, and we are excited to announce our new quarterly formatted newsletter, beginning in March, which will contain expanded content.

VIX Futures Last Trade Dates

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Contract Last Trade Date
January 2013 01/15/2013
February 2013 02/12/2013
March 2013 03/19/2013
April 2013 04/16/2013
May 2013 05/21/2013
June 2013 06/18/2013
July 2013 07/16/2013
August 2013 08/20/2013
September 2013 09/17/2013


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Daily Volume Surpasses 200,000 Contracts for First Time in CFE History

Brodsky At CBOE Risk Management European Conference: Announces Plans For 24-Hour VIX Futures Trading And CFE London Hub

A CBOE Community Blog
Whats on Our Minds: Read the CBOE Blogs

Market Summary & Analysis

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Market Summary and Analysis is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation.

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Volatility: the year in review

The over-riding theme of volatility during 2012 was that it was subdued and flat for most of the year at what can only be considered low levels (historically), which came as a complete shock to many traders who had spent a great deal of money paying for protection. The supposedly volatile events, such as the European debt crisis, the U.S. Presidential election, and the "fiscal cliff" either never materialized or did not cause an increase in volatility.

The CBOE Volatility Index (VIX) hit a level of 48 in August 2011 and declined rather steadily from October 2011 through February 2012. That latter decline took VIX from 37 down to 14. After that, except for a brief excursion up to 28 in May and June, VIX spent the entire year under 21. In fact, VIX has been below 19 for almost the entire last five months of the year. Its highest probe during that time recently occurred on Friday, December 21, but by the end of the day, it had traded back down – forming a negative intraday reversal bar on its chart. These movements can be seen in Figure 1.

Figure 1 Source: McMillan Analysis Corp

This was an especially low level of VIX for the fall of the year, a time when the stock market often sells off rather sharply. Consider Figure 2, which is a composite of VIX over 23 years of trading, encompassing the years 1989 through 2011. Note that this is a composite of VXO (the "old" VIX, the volatility index of the S&P 100 Index, OEX). The reason we use VXO is that it has a history that extends farther back in time than the current VIX does. However, using VIX itself would not change the conclusions that can be drawn from looking at Figure 2.

Figure 2 is created by taking VXO on the first trading day of the 23 years in question, and plotting the average on that day as the leftmost point. The second point is the average VXO on the second trading day of the year, and so forth.

Not unexpectedly, the low point of volatility occurs on about July 1st of the year (point C on chart). However, it is somewhat surprising to see how quickly volatility usually increases after that, eventually culminating in a peak in October (point F). From there, volatility falls off sharply into the end of year. In fact, by Christmas, VXO is almost back down to the yearly lows (point G). That is a typical year, and most years follow this pattern somewhat closely although any one year may deviate from the average pattern. Such a deviation likely occurred in 2012. There is some precedent that in Presidential election years, which 2012 was, the peak in volatility is delayed until the middle of the year, with declining volatility thereafter. That is more or less what happened in 2012.

Figure 2 Source: McMillan Analysis Corp

One might ask why volatility behaved in this manner in 2012, and the simple answer would be that 2012 was mostly a steady bull market year. Bull markets generally exhibit less volatility, and that was certainly the case in 2012. In fact, the 20-day actual volatility (also called statistical or historical volatility) fell from about 25% at the beginning of the year to under 10% in February. It then remained subdued for the remainder of the year, briefly reaching a high of 20% in June and then dropping to 7% in late August. Currently it is sitting at about 10%. Thus, VIX ,by comparison, has not really been "too low," for it is rare to see VIX exceed the 20-day historical volatility by more than 8% (and it's usually more like 4% higher than the 20-day historical).

A more typical year for both historical and implied volatility in 2013 may be expected. Typically in the first year after the President is elected, the market rallies for a while, but then tops and declines, sometimes rather sharply. That would imply that volatility would remain subdued for a while and then rise in accord with a falling stock market.

The fiscal cliff scenario may have some influence on volatility, but in reality the stock market (and hence the volatility market) has been ignoring the fiscal cliff to date, and that trend can be expected to continue. While the media is preoccupied with the fiscal cliff, most traders are not.

Protection Trade

We have written about the "protection trade" in this newsletter many times this year. That is the trade wherein institutional traders both buy stocks and they buy protection. That protection could be in the form of S&P 500 (SPX) puts or in the form of VIX calls. Ever since November of 2011, this has been a popular trade, although it has not paid off very well. True, the S&P 500 Index has climbed in price, so any stocks that were bought in broad-based portfolios likely rose in price as well. However, since VIX has remained so subdued, any money spent on protection in 2012 has likely proven to be a loss.

In reality, that is exactly the way that anyone who is buying protection would like things to develop since one really does not want to collect on the purchased protection. The protection trade, however, involves the purchase of options priced above fair value in many cases, and so the losses on the protection side of the trade were larger than normal.

At the current time, however, protection is cheaper than it has been for a while. The term structure of the VIX futures, while continuing to slope upward, is less steeply sloped than it has been all year. In fact, the front month, January, VIX futures are trading at a discount to VIX, something that also has not been the case for a year now.

So, the protection trade is now more viable than it has been in some time. If its adherents still are enamored with the strategy (provided they are not tired of under-performing their competitors who did not purchase protection), they could provide continued support for the broad stock market.


2012 was a year of subdued volatility and rising stock prices. Unless VIX closes above a level of 19 through 21, there is little reason for the stock market bulls to be worried. However, if VIX were to begin to trend higher and were to close above those levels, then a protective strategy would be called an option worth considering.

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Volatility Index Arbitrage: A Specific Case

The article below is provided by Michael McCarty. Mr. McCarty is the founding member and chief strategist of Differential Research.

CBOE Futures Exchange, LLC (CFE) lists futures and security futures on six different volatility indexes that provide up-to-the-minute market estimates of the expected volatility of several different asset classes. These six unique products are calculated by applying the CBOE Volatility Index® (VIX®) methodology to CBOE-listed options on a diverse group of stock indexes and exchange-traded funds (ETFs). This column for the last few months has focused discussion on the potential for inter-market volatility arbitrage opportunities among these products and the possibility to capitalize on changing relative volatility expectations between asset classes.

This month we will look at a specific relationship between implied volatility for the S&P 500 Index (SPX) as represented by the VIX and implied volatility for the NASDAQ-100 Index (NDX) represented by the CBOE NASDAQ-100 Volatility Index® (VXN®).

With the reintroduction of VXN futures this year, we note that data is very limited and relationships are likely to change as trading volumes and open interest grow for both the options on the underlying indexes used in the calculation and the volatility futures markets. However, a small data set provides a simple platform for demonstrating the spread analysis process.

As a starting point to explore why implied volatility differs for the SPX and NDX indexes, we first look at the differences between the two indexes. The SPX Index is a capitalization weighted index, as described by S&P:

"...500 leading companies in leading industries of the U.S. economy. Although the S&P 500® focuses on the large cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market."

The NDX Index is a cap-weighted index , as described by NASDAQ:

"...100 of the largest domestic and international non-financial securities listed on The Nasdaq Stock Market based on market capitalization. The Index reflects companies across major industry groups including computer hardware and software, telecommunications, retail/wholesale trade and biotechnology. It does not contain securities of financial companies including investment companies."

Differences in risk expectations for different sectors or components of the index are likely to drive differences in values for the VIX and VXN indexes and futures. For example, Apple Computer (AAPL) is the largest constituent stock in both indexes. However, recently Apple Computer comprised approximately 18.5% of the NDX Index but only 4.4% of the SPX Index. (Sources S&P and NASDAQ). Moreover, the relative influence of Apple is likely greater on the NDX Index due to the greater relative representation of Apple suppliers and distributers. This fact is well known and motivates a popular equity spread trade that seeks to arbitrage the prices of the SPX and NDX Indexes around important dates for Apple, such as earnings reports and new product introductions. Success however is directionally dependent, requiring knowledge of whether Apple trades up or down on the announcement, and is not a prerequisite for success in a volatility arbitrage trade. Volatility is likely to decline regardless of outcome as the "uncertainty" passes and the perceived risk is diminishes.

Second, we look at the potential for any differences between the calculation of the indexes and the settlement process for the futures. VIX and VXN futures both have a $1,000 contract multipliers and their settlement values are based on the A.M. settlement values of the option series making up each index. The settlement value for VIX and VXN futures are both calculated using the VIX methodology.

Finally, we will look at data for both the front-month futures and longer term futures and at the relationship between the calculated underlying volatility indexes. For our analysis we use daily closing prices for the VIX and VXN Indexes from 1/4/2010. We use daily settlement prices for the front month futures from 6/20/12, labeled VX1 and VN1. It is important to note that constant serial futures, like the constant front-month future, are disjointed series. The underlying future changes each month, positions or spreads may need to be rolled to subsequent months at or before resulting in additional costs. Also the indexes are not tradable products.

However, since we are most interested in ranges and extremes, our analysis will suffice.

Sources: CFE, Differential Research, LLC

Looking at the graph of settlement prices, it is apparent that the VIX and VXN Indexes appear to be highly correlated, as are the two futures. Likewise, the VIX and VXN Indexes and the futures appear to be highly correlated, lending credibility to the value of analyzing the longer historical data available for the volatility indexes.

Sources: CFE, Differential Research, LLC

The summary statistics data further confirms similar distributions.

Sources: CFE, Differential Research, LLC

The futures data suggests that the VIX and VXN Indexes and respective futures are more highly correlated -than they appear to be.

Sources: CFE, Differential Research, LLC

Looking at the spreads in dollar terms:

Sources: CFE, Differential Research, LLC

While the maximum VXN premium to the VIX Index and the VN1 premium to the VX1 are close, the VN1 futures discount for the shorter period is significantly less than the maximum VXN discount to the VIX for the longer period.

Sources: CFE, Differential Research, LLC

Of particular interest, the VXN and VN1 premiums to the VIX and VX1 are near the highest level for the periods under review.

Sources: CFE, Differential Research, LLC

That extreme is also present when the spread is viewed on a percentage basis.

Sources: CFE, Differential Research, LLC

Review of 2012 VIX Futures Trading Strategies

By Mark Shore, Founder of Shore Capital Management.

In 2012 we discussed methods of trading the CBOE Volatility Index (VIX) futures contract at CBOE Futures Exchange, LLC (CFE). In this article, we will review the previously discussed trading methods and how to apply them to the current market environment.

Liquidity is an important factor for trading. Several times during 2012 VIX futures volume reached record levels including a record high of 2,734,248 contracts in November, Which was a 233% increase from November 2011's 822,017 contracts and which broke the prior trading volume record set in October by 12%. In November the Average Daily Volume for VIX futures was 130,202, an increase of 233% from November 2011. To date, the November VIX futures total volume is 86% higher than it was in 2011 and year-to-date trading volume is 21,344,285 contracts versus 11,455,871 in 2011.i

In past articles we discussed the use of four VIX futures trading strategies: 1) utilizing support and resistance to seek contrarian changes at range bound extremes; 2) crossing of moving averages; 3) utilizing the Aroon Oscillator; and 4) using the True Range to trade VIX futures. In this article the parameters have been set to the same level as they were set in previous articles.

We begin discussing the support and resistance methodology. We originally discussed this in the September 2012 article "VIX Trading Strategies". The VIX futures contract historically tends to find major price support between 10 and 15 and it finds major price resistance around 40 (with the exception of the financial crisis). As you will notice in the monthly chart below VIX futures tend to rally after forming a floor at or near a price of 15. This most recently occurred in 2010 and 2011. During the last several months, the VIX contract has once again found the price of 15 to be major price support area. Could this be the foundation of a floor for a rally in 2013?

Chart 1: Monthly Nearest VIX Futures Chart with Support and Resistance

Sources: www.barchart.com

Upon examination of the daily nearest chart for 2012, when the VIX futures falls in the range of 15, it tends to base and then rally. From a risk management perspective, this could be a situation to reduce or unwind short VIX futures positions. Could this imply a breakout or contrarian trade in 2013?

Chart 2: Daily Nearest VIX Futures Chart with Support and Resistance

Sources: www.barchart.com

The second methodology is crossing moving averages. As noted in the September 2012 article, "VIX Trading Strategies" we utilized the 5 day (green) and 20 day (red) moving averages. The January 2013 VIX futures daily chart below shows several examples of long (green circles) and short (red circles) signals as the VIX futures market trends lower since June of 2012. As the market nears expiration the major resistance price is 15. Will the January 2013 VIX futures contract move sideways or find a floor to rally from?

Keep in mind, that there may be signals indicating either close to the major price support range or major price resistance range. For example, a long signal near 15 may offer greater probability than a short signal near 15. A short signal near 40 may offer greater probability than a long signal near 40.

One issue of moving averages is the signals tend to lag as averages prices over a certain period of time is reached, but in a trending market a lagging indicator may offer added value.

Chart 3: January 2013 Daily VIX Futures Contract with 5 and 20 Day Moving Averages

Sources: www.barchart.com

The third methodology is the Aroon Oscillator developed by Tushar Chande in 1995. A more in-depth discussion of the Aroon Oscillator is found in the October 2012 article "Trading the VIX Futures with the Aroon Oscillator". The oscillator is a range bound between +100 and -100. The oscillator usually considers the area of 0 as a range bound market or a weak trend. As the oscillator moves away from zero, the trend is interpreted to be gaining strength. In this article the parameter was set to 20 days.

The January 2013 daily VIX futures contract in Chart 4 below, demonstrates tops (red circles) of the VIX futures market coincide with peaks in the Aroon Oscillator. Currently it could be either in a trading range or beginning to form a bottom (green circle) as the Aroon Oscillator is near -100 and near the major price support of 15. The analysis of the market becomes more interesting when multiple indicators are integrated into the analysis. The Aroon Oscillator tends to be less lagging of an indicator than moving averages when analyzing VIX futures.

Chart 4: January 2013 Daily VIX Futures Contract with the Aroon Oscillator

Sources: www.barchart.com

The fourth and final trading indicator is the True Range and Average True Range developed by Welles Wilder in 1978. See the November 2012 article "Trading the True Range of the VIX Futures" for more discussion.

True Range is considered a metric of a market's activity and posits that the higher the number, the more likely the market will change direction. A lower number indicates a weaker trend or indication of a trading range. True Range is defined as the maximum value of the following: 1) today's high - today's low; or 2) yesterday's close - today's high; or 3) yesterday's close - today's low. The Average True Range is a moving average of the True Range. We set the Average True Range parameter to 7. Utilizing the average helps to smooth out the True Range.

In Chart 5 below, the True Range and Average True Range are both valued at 0.75. Will the True Range rally from the average or break continue to decline? It is the extreme moments of highs and lows that may add the most value when analyzing the True Range relative to the VIX futures along with direction of the Average True Range.

Chart 5: January 2013 Daily VIX Futures Contract with the Average True Range

Sources: www.barchart.com

In summary, when developing trading strategies, some traders prefer to use one indicator and others prefer to use multiple indicators to create a market profile. In Chart 6 below, the four trading strategies are viewed simultaneously. As noted earlier in this article, each of these indicators implies a sideways market or a formation of bottoming VIX futures in the near term.

Chart 6: January 2013 Daily VIX Futures Contract with All Four Indicators

Sources: www.barchart.com

This article is not intended to recommend a specific trading strategy, but to educate the reader on various strategy ideas to investigate beyond spreads or hedging of volatility futures.

If you have a favorite volatility futures trading strategy you would like to share, please email: info@shorecapmgmt.com

i "Total VIX Futures Volume Reaches New All-Time High in November", December 3, 2012, CFE Press Release


Please direct questions concerning this circular to:

Jay Caauwe

Jennifer Fortino

About Larry McMillan and McMillan Analysis Corporation
Lawrence McMillan is the recipient of the Sullivan Award for 2011, awarded by the Options Industry Council in recognition of his contributions to the Options Industry. Professional trader Lawrence G. McMillan is perhaps best known as the author of Options As a Strategic Investment, the best-selling work on stock and index options strategies, which has sold over 200,000 copies. An active trader of his own account, he also manages option-oriented accounts for certain individuals and in addition, he is the Portfolio Manager of The Hardel Volatility Arbitrage Fund (a hedge fund). In a research capacity, he edits and contributes to his firm's publications: Daily Volume Alerts, The Option Strategist and The Daily Strategist—derivative products newsletters covering equity, index, and futures options. Finally, he speaks on option strategies at many seminars and colloquia in the United States, Canada, and Europe. He is quoted in publications such as The Wall Street Journal, Barron's, Technical Analysis of Stocks and Commodities, Data Broadcasting's Exchange magazine, Futures Magazine, theStreet.com, and Active Trader Magazine. In these capacities, he is the President of McMillan Analysis Corporation, which he founded in 1991. Prior to founding his own firm, Mr. McMillan was a proprietary trader at two major brokerage firms—primarily Thomson McKinnon Securities, where he ran the Equity Arbitrage Department for nine years.

About Michael McCarty
Michael McCarty is the founding member and chief strategist of Differential Research. An independent provider of derivative research for institutional investors. Differential Research was founded to capitalize on the growing importance of risk and volatility analysis in the investment process. Mr. McCarty is a frequent guest on BloombergTV, Fox Business News and CNBC, in addition to being quoted regularly by the financial press. Mr. McCarty also speaks frequently on the topics of risk and volatility at investment industry conferences.

Michael McCarty was formerly the Chief Strategist at Meridian Equity Partners, an independent broker dealer. As director of the firm's Option Market Operations, Mr. McCarty published two widely-read notes per day, targeting on the US marketplace and uncovering Noteworthy Option Activity.

Born in the Republic of Panama and raised in Central Florida, Mr. McCarty's fascination with the financial markets came early on, first studying finance and history at Emory University, then obtaining a Masters Degree in Finance from New York City's Baruch College – Zicklin School of Business. His vast knowledge and deep understanding of the equity and derivative markets, the result of a twenty-five year Wall Street career as sales-trader, analyst and market strategist has allowed him to accumulate a significant following of the most respected and accomplished investors worldwide.

About Mark Shore
Mark Shore has more than 20 years of investment, research and futures experience. In 2008 he founded Shore Capital Management LLC where he consults in alternative investments regarding due diligence, research, educational workshops and business development. He is a frequent speaker at alternative investment events. He has published several papers on alternative investments and asset allocation. His research is found at www.shorecapmgmt.com.

Mr. Shore is an Adjunct Professor at DePaul University's Kellstadt Graduate School of Business where he teaches a graduate level managed futures/ global macro course. He is also an Adjunct Instructor at the New York Institute of Finance and a Contributing Writer for Reuters HedgeWorld and the CBOE Futures Exchange. Prior to founding Shore Capital, Mr. Shore was Head of Risk for Octane Research Inc ($1.1 billion AUM) in NYC from 2007 to 2008, where he was responsible for quantitative risk management analysis and due diligence of Fund of Funds. He chaired the Risk Management Committee and was a voting member of the Investment Committee.

Prior to joining Octane, he was at VK Capital Inc from 1997 to 2006, a wholly owned Commodity Trading Advisor ($250 million AUM) of Morgan Stanley. As Chief Operating Officer of VK Capital, Mr. Shore provided research and risk management expertise on portfolio issues, product development and business strategy. Mr. Shore graduated from DePaul University with a degree in Finance. He received his MBA from the University of Chicago.

The information in this newsletter is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many of the matters discussed are subject to detailed rules, regulations, and statutory provisions that should be referred to for additional detail and are subject to changes that may not be reflected in this newsletter. The strategy discussions contained in this newsletter are designed to assist individuals in learning how volatility and variance futures as well as other volatility-based derivatives work and understanding various volatility derivatives strategies. The strategies discussed are for educational and illustrative purposes only and should be not be construed as a recommendation to buy or sell a security or futures contract or to provide investment advice. Additionally, commissions and other transaction costs have not been included in the example strategies and will impact the outcome of security and futures transactions and must be considered prior to entering into any transactions. Investors considering volatility-based derivatives should consult a professional tax advisor as to how taxes affect the outcome of contemplated transactions in volatility-based derivatives. The charts and/or graphs contained herein are intended for reference purposes only. Past performance is not indicative of future results.

The views of third party contributors to this newsletter are their own and do not necessarily represent the views of CFE or its affiliates. Third party contributors are not affiliated with CFE. This newsletter should not be construed as an endorsement or an indication by CFE of the value of any third party product or service described in this newsletter.

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 (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.

The methodologies of the CBOE Volatility Index (VIX) and the CBOE DJIA Volatility Index (VXD) are owned by CBOE and may be covered by one or more patents or pending patent applications.

Copyright CBOE Futures Exchange, LLC. All rights reserved. CFE, CBOE, Chicago Board Options Exchange, CBOE Volatility Index, VIX are registered trademarks of Chicago Board Options Exchange, Incorporated.