• Introduction
• Announcements
• Volatility In Focus - 2007 Year in Review featuring Larry McMillan

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.

To contact the CFE, please click here.

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

2007 IS BUSIEST YEAR YET FOR CBOE FUTURES EXCHANGE; Trading Tops One Million Contract Mark For The First Time, Year-End Volume Increases 138% Over Year-Ago

Three new and important volatility indices:

CBOE S&P 500 ® VARB-X Strategy Benchmark – VTY

CBOE S&P 500 3-Month Volatility Index ® - VXV

Also:

VIX Futures Last Trade Dates

2007 in Review is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation. Click Here for more information about Mr. McMillan.

Year End 2007 Recap

2007 has been a very interesting year for volatility and for volatility derivatives. When the year began, VIX was at historically low levels, but as the bull market aged and investors became more skittish, volatility increased – at times, dramatically. In retrospect, it was like no year in history, in terms of volatility changes.

Meanwhile, volatility derivatives came alive as speculative and hedging vehicles, especially once the broad stock market broke away from the tight, upward trend of its four-year bull market.

2007 In Review

In early 2007, VIX was at or below 10, testing its all-time lows (previously set in late 1993 and early 1994). Volatility traders did not expect that to last, though, as the futures typically traded with a healthy premium – indicating that expectations were high for VIX to increase in value over the course of the year. Table 1 shows an example of the distribution of VIX futures in mid-January. Notice the hefty premium on the May and August futures at that time.

Source: MAC

But the longer-term futures had been similarly priced for some time, and it seemed that expiration after expiration saw VIX hugging the low end of its historic trading range. That began to change in late February when the Chinese market stumbled over a threatened increase in margin rates. In the U.S., the reaction was swift and negative, as the S&P 500 Index ("SPX") lost 50 points in one trading day. That was really the “shot across the bow” that began to change the volatility environment for the rest of the year.

Figure 1 shows the entire trading history of VIX and the VIX futures for 2007. VIX is the green line. Note that the sharp late February decline in SPX caused VIX to spike higher – up to nearly 20. What was very interesting, though, was that the futures did not follow VIX higher. In fact, futures traders were not worried about the market at all. Even though stock option traders were panicking to some extent (which is what caused VIX to rise so sharply), futures traders said, in effect, “Do not worry. This is a false move. Soon VIX will be back down again.” And they were right – VIX was back down to 12 in just a couple of weeks.

For most of the next few months SPX continued to rise again, eventually reaching new all-time highs in July. Figure 2 shows the SPX chart for 2007. Meanwhile, VIX hovered in the 13-14 range, and the VIX futures traded with very small premiums. But near the end of June and into July, a small divergence started to take place: VIX was rising while SPX was making new highs. That in itself was not t terrifically unusual, but something else was: the futures began to climb with VIX. In other words, no longer were the futures languishing below VIX, but now they were rising – a much more bearish scenario than had been seen in February. By the time that SPX reached its peak in July, VIX had risen to 17 and the futures were slightly higher than that. In other words, both futures and option traders were getting a little nervous about the stock market.

It did not take long for that nervousness to materialize into something real. The sub prime debt crisis began to unfold in earnest, and SPX dropped 180 points in a month, eventually bottoming out in mid-August at 1370 (intraday) and 1410 on a closing basis.

Figure 1 Source: McMillan Analysis Corp.

Figure 2 Source: McMillan Analysis Corp.

As SPX was plunging, VIX was soaring, eventually trading up to 37 intraday and closing near 31 on that mid-August day. But, even more importantly, once again the VIX futures (and their relationship to VIX) changed in a way that was predictive for the stock market. As VIX made those new yearly highs, only the near-term August futures followed along. The other futures remained subdued, trading at a discount to VIX. Table 2 shows the construct of the VIX futures as compared to VIX at the close on August 16 th – the day of the bottom. As you can see, the longer-term futures were trading at huge discounts, taking a “What, me worry?” attitude about what was seemingly a very serious stock market decline.

Again, the futures were predicting that VIX would drop (and, by inference, the stock market would rise). And again, the futures were correct, as the market bottomed at that point and SPX staged a strong 200-point rally to new all-time highs by early October!

Source: MAC

By this time, of course, everyone knew that the “volatility genie” had been let out of the bottle and there was not going to be any way to get it back in. So, VIX could not – and did not – decline too far, for there was no way that volatility was going to return to the stoic norms seen early in 2007. Rather, VIX and the futures remained at high levels – in the low 20’s – indicating that a higher volatility level is expected to be here to stay, at least for the foreseeable future.

To prove the point, SPX bounced back and forth in a very volatile fashion for the remainder of the year. From its new all-time highs in early October, SPX plunged 160 points by late November, and then staged a strong rally in early December, before declining rather sharply once again into year-end.

VIX movements, of course, mirrored SPX movements as they usually do, but it was the futures alignment with respect to VIX that has become the important piece of data to observe. As you see from Figure 1, VIX futures traded at a healthy premium in early October (a negative sign), just before the market fell. But, by mid-November, with VIX rising to 31 again, the futures traded at a bullish discount. So the futures continued to “call” the market with stellar accuracy.

After that, both VIX and its futures contracts hovered together at virtually identical prices in late November and early December. But the year finished with one final noteworthy message from the VIX futures. As traders expected year-end bullishness, or perhaps just a calm market, VIX dropped during the week leading up to Christmas, and was trading below 19. However, the futures were not buying it (see the far right-hand side of Figure 1). The large premium on the futures was a warning sign that the bears still had some ammunition left. Sure enough, the year ended (and 2008 began) with SPX swooning in a wave of selling that carried it down by 60 SPX points.

Finally, it should be noted that the volatility of VIX (i.e., the “volatility of volatility”) increased dramatically this year. Early in the year, the 20-day historical volatility of VIX was near 60%, but by November it had risen to 190%! A more stable measure, the 100-day historical volatility, rose from 70% early in 2007 to 150% by year-end. Among other things, this change in VIX volatility affects the pricing of VIX options, of course.

Summary

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.

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