For more information on the CBOE Volatility Index^® ("VIX"), volatility and variance futures including brokers, ISVs, symbols and product specifications, visit www.cboe.com/cfe.

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Futures in Volatility includes several sections: Market Summary and Analysis, Trading Strategy Ideas, Volatility in Focus and Events. Market Summary and Analysis includes commentary related to VIX, VIX futures and other volatility products, as well as charts and data related to these markets. Trading Strategy Ideas features strategies focused on trading volatility products. Volatility In Focus includes feature articles and education focused on volatility related concepts. And, Events features upcoming CFE and Chicago Board Options Exchange (CBOE^®) conferences, seminars and webinar presentations.

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Press Releases

AUGUST IS THIRD CONSECUTIVE MONTH OF RECORD VOLUME AT CBOE FUTURES EXCHANGE; Busiest Day In CFE History, Numerous Records, Propel Trading To 251% Increase Over Year-Ago

VIX Futures Last Trade Dates

Market Summary and Analysis is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation. Click Here for more information about Mr. McMillan.

The new era of increased volatility has persisted, even though the S&P 500^® Index (SPX ^SM) has rallied over 150 points from its August lows. Typically, a rally of that magnitude would knock the CBOE Volatility Index^® (VIX)^® down dramatically, but in this case it did not. Traders were, and are, somewhat apprehensive about events and potentially sharp market movements in the upcoming months.

As a case in point, VIX was trading at extremely elevated levels prior to the FOMC Meeting this past Tuesday (9/18/07). Clearly, traders were very nervous about the market’s reaction to whatever move the Fed was going to make. It was probably the case that VIX would have fallen no matter what the Fed did. In reality, the half-point double rate cut (Fed Funds and Discount) caused the stock market to rocket to the upside, and VIX dropped about 6 points. To illustrate this concept, it is useful to know that VIX generally trades at a level near the 20-day historical volatility of SPX. After the wild gyrations of August, the 20-day historical volatility of SPX was computed to be between 20 and 21 on most days in early September. At that time, VIX was trading near 25 or 26.

Source: MAC

Traders could draw several valuable conclusions from this data. The first is that VIX was trading substantially higher than the actual volatility of SPX, so it seemed overly inflated. The shape of the futures pricing curve confirms this. Note that each successively longer-term future is trading at a lower price than its predecessor. This inverted shape of the pricing of the futures implies that VIX will soon drop in price.

In mid-August we saw a similar shape, and VIX dropped as the market rallied. The same thing happened again this week – VIX fell six points and SPX rallied nearly 40 points, all in a few hours after the FOMC Meeting ended, and the rate cuts were announced. However, one should be careful about drawing the conclusion that the stock market will always rally after the pricing curve has the above shape. As stated earlier, VIX was likely to fall even if the Fed made a less bullish move, just because it was due to come back more into line with SPX historical volatility.

Somewhat ironically, the Fed move came on the last day of trading in the September VIX futures and options. Short sellers thus made out very well, as did buyers of September VIX puts, at least down through the 22.50 strike price. When all was said and done, the September VIX futures settled at 20.29. That was well below August’s settlement price, but is still higher than every other previous VIX settlement since the futures began trading in March of 2004.

Once the FOMC meeting was over, and the market had rallied so strongly, VIX settled in near 20, right in line with historical volatility, and the shape of the futures pricing curve changed dramatically, as shown in Table 2.

Source: MAC

Note how the futures are now congregated around the VIX price, and there is only a slight inversion to their prices. In other words, the futures are “saying” that VIX isn’t expected to change dramatically, at least not until some other market-moving event comes along.

In the final analysis, VIX is still trading at a relatively high price, near 20. Earlier this year it was routinely trading in the 10-12 range. Figure 1 shows the price chart of the various futures contracts, compared with VIX (green line), over the past year and a half.

Figure 1

If the market continues to be this volatile, it makes things more interesting for buyers of both puts and calls, since the market can make sharper moves. But perhaps the biggest beneficiaries of a high VIX are premium sellers – covered call writers, naked put sellers, and put credit-spread sellers. These sellers can now create relatively conservative positions (using strikes well below current market prices) with relatively large expected returns. That is not possible with VIX near 10.

Strategy – The "Reverse" Futures Calendar Spread

Many professional traders approach VIX trading via spreads rather than with outright long or short positions. There are two main reasons for doing so: 1) the position is hedged so the dollar risk is less than that of an outright position, and 2) the margin for a spread trade is quite low, so high returns can still be generated from spread trading, even though the absolute dollars of potential profit might be less than that of an outright speculative position. This month, we’re going to review the “reverse” spread, because of the shape that the futures pricing curve has been taking. When the futures are trading with an inverted shape – as shown in Table 1 above, then they are essentially predicting that VIX will drop in price (and, by inference, the futures curve should flatten when that happens).

Suppose that as the Fed meeting approached, one was convinced that VIX would drop, whether or not the Fed lowered rates. A trader might sell a near-term futures contract (October, say) and buy a longer-term contract (say, November).

Example: on Sept 17th, a trader establishes the “reverse” spread at the settlement prices shown in Table 1:

Sell 1 Oct VIX future at 24.32
Buy 1 Nov VIX future at 22.80

Thus, the spread was established a 1.52, Oct over Nov (or, in option parlance, at a "credit" of 1.52)

After the Fed move, VIX dropped and the futures prices were as shown in Table 2, and the position could have been removed:

Buy 1 Oct VIX future at 20.82
Sell 1 Nov VIX future at 20.75

So the spread could be bought back at 0.07, Oct over Nov—a profit of 1.45 points, or $1,450 dollars per spread, less commission.

One might say that if you had expectations of a price drop, you could have merely sold the Oct futures at 24.32 and bought them back at 20.82, a profit of 3.50 points, or $3,500. That is true, but the exchange minimum margin for the futures position is $2,250 (initial) while it’s only $50 for the calendar spread. Hence the calendar spread has a higher rate of return.

The leverage available in calendars can make them very risky investments, though. Thus the trader should still use mental stops on any calendar spread position to limit risk and should be cautious about establishing overly large positions.

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Study on Volatility Index as a Diversification Tool

In 2007 the Fund Evaluation Group (FEG) consulting firm issued a new study entitled "Evaluation of BuyWrite and Volatility Indexes—Using the CBOE DJIA BuyWrite Index (BXD) and the CBOE DJIA Volatility Index (VXD) for Asset Allocation and Diversification Purposes." The paper studied the 109-month period from October 1997 to November 2006. The FEG study presented several findings on the 9-year performance of the VXD spot index, including:

• Volatility Index Can Reduce Portfolio Volatility . Including a small (10%) allocation to the CBOE DJIA Volatility Index (VXD) could have reduced the volatility of an all-stock portfolio by about 26%, without materially affecting returns.
• Low Correlation and Diversification . The VXD and the DJIA were inversely correlated (-0.62) over the course of this study. The study showed that VXD increased more during market declines (VXD reacted more to stock market declines than to stock market advances), indicating that VXD has potential as a diversification tool.
• Impact on Risk-Adjusted Returns . The inclusion of a small (5%) allocation to the VXD Index boosted risk-adjusted returns for a stock-oriented portfolio, and lowered the risk-adjusted returns for a fixed-income-oriented portfolio.

Exhibit 14 of the FEG study showed the impact of adding 5% allocations of the VXD spot index to an all-stock DJIA portfolio. Please note that (1) the study used prices of the VXD spot index because long-term data on prices of VXD futures was not available, and (2) that the futures on volatility indexes often have had less price movement than the volatility spot indexes.

Exhibit 14: Efficient Frontier: DJIA vs. VXD in 5% Intervals
(Monthly Data October 31, 1997 through November 30, 2006)

Unique Features of Futures and Options on the CBOE’s Volatility Indexes

Futures and options on the CBOE’s volatility indexes have several features that distinguish them from most equity and index options. Here are links to unique features of VIX options:

• Pricing Based on Forward VIX Value
• Pricing Can Be Different for a Number of Reasons
• Wednesday Settlement
• Special Opening Quotation Price
• Negative Correlation to Stock Indexes
• High Volatility of Volatility

Links to More Information about Volatility Indexes

• VIX Options FAQ
• VIX Options Quick Reference Guide
• VIX Options Specifications
• VIX Options Video on CBOE-TV Channel 3
• VIX Options Daily Market Data
• VIX Options Delayed Option Chain
• VIX Historical Price Data
• VIX Futures Price and Volume Data
• VIX Price Charts
• VIX White Paper
• VIX Futures Primer
• VIX Bibliography

www.cboe.com/volatility

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About CBOE Futures Exchange CBOE Futures Exchange (CFE^®) is an all-electronic open access exchange, which utilizes the CBOE’s^® state-of-the-art trading system, CBOEdirect^®. CFE is the leader in providing innovative volatility risk management futures products, including VIX^® and variance futures, which enable market participants to manage volatility risk, as well as trade volatility directly. Access to CFE is available through numerous brokers, ISVs or directly via the CBOEdirect API or CBOE’s HyTS^® terminals. CFE trades are cleared by the AAA-rated Options Clearing Corporation (OCC). To contact the CFE, please click here. About Larry McMillan and McMillan Analysis Corporation 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.

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Copyright © 2007 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 (CBOE). VXD and VXN are servicemarks of CBOE. All other trademarks and servicemarks are the property of their respective owners.

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 indexes are owned by CBOE and may be covered by one or more patents or pending patent applications.