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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Contact Information

Please direct questions concerning this circular to Jay Caauwe at (312) 786-8855 or caauwe@cboe.com.

VIX Futures Last Trade Dates

Happy Birthday, CFE^®

The fourth anniversary of listed volatility futures occurred on March 26th (Variance futures followed 37 days later - on 5/18/04). Things have come a long way since then - both in the way the volatility derivatives markets have developed and in the way the market's volatility itself has changed. Four years ago, everyone was anxious to buy futures to hedge stock portfolios, and so the futures began their existence with huge premiums (see left-hand side of Figure 1). That did not last long, though, as the futures prices eventually declined, to get much more in line with VIX^® itself. They have remained in that relationship to VIX ever since.

Perhaps more significant, though, is what has happened to market volatility. In looking at the Figure 1 below, it is obvious that there were two phases of volatility. The first, which lasted from the inception of futures trading until July of 2007 was a period in which VIX was extremely, historically low, and the futures refused to jump higher even if VIX did (witness June, 2006, or February, 2007).

But that all changed in August of 2007, and now we are in a different era. The formations on the right-hand side of Figure 1 had not been seen since futures trading launched. Now, VIX is much, much higher in absolute terms and swings wildly about the futures prices (colored lines). The futures are tightly bunched together and trending steadily higher over time.

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 Current Situation

VIX has dropped rather dramatically during the last month. The VIX futures settled at 21.78 for April, whereas the March settlement had been 25.67. One might think that such a drop in VIX would mean that the broad stock market was considerably higher (they move opposite to each other), but such is not the case. True, the S&P 500^® Index^® is higher, but the VIX movements - especially those in the last two weeks - have not been reflected in S&P 500 Index movement. Notably, VIX made a new yearly low on April settlement day, whereas the S&P 500 Index did not break out to a new yearly high.

This sort of divergence is usually resolved by looking at what the futures are doing. The futures are not in agreement with VIX, for they have not dropped down to new yearly lows, as VIX did. We saw a similar thing last December, when VIX dropped to a new relative low near 18, but SPX did not exceed its early December highs. We all know what happened shortly thereafter - a nasty decline in the S&P 500 Index. In essence, VIX was wrong. But the clue back then - as it is now - to keep traders focused on the proper assessment of the situation was that the near-term futures contracts were trading with very large premiums in December. They were saying that VIX was going to rise to get back in line with futures. And rise it did, during the ensuing market drop.

Currently, the May VIX futures (i.e., the front month now that April has expired) are trading with sizeable premiums to VIX as well (see Table 1). Again, this is generally a bearish indication. We will observe how the situation plays out, but so far - in the admittedly relatively short history of VIX futures trading - the VIX futures have been a far better predictor of market movements than VIX itself has.

The current level of VIX futures premiums is shown in Table 1. You can see that they are trading with a substantial premium to VIX (anything above 85 cents or so should be considered to be substantial).

Source: MAC

Figure 1 Source: McMillan Analysis Corp.

Trading Strategy - A Hedged Strategy When VIX & VIX Futures Diverge

When there is a large discrepancy between VIX and its front month futures contract, we know that eventually the difference will be resolved. That is, eventually, VIX and the front month futures (May, at the current time) will converge in price. So far, it has been the case that the futures do not move much at all, but it is VIX that has to move to become in line with the futures. If that were the only way that this scenario could play out, then one would always be correct in taking a speculative position in S&P 500 Index derivatives to play that eventual VIX move.

However, we know that the other scenario could possibly occur - that the futures move to get in line with VIX. If that happened, then a speculative position in S&P 500 Index derivatives would likely not be profitable.

Let's take the current situation, using these recent prices:

VIX: 20.5
May VIX futures: 22.5
S&P 500 Index: 1365


Now if we expect VIX and the May futures to converge, something has to move two points - either VIX has to rise, or May futures have to fall.

How could we hedge both sides of this scenario? By shorting May futures (in case they fall) and by shorting the S&P 500 Index (in case VIX rises, the S&P 500 Index will fall). We can short the S&P 500 Index via the S&P futures or e-mini futures, for example. We could also short the S&P SPDRS^® (symbol: SPY) which are worth 1/10th the value of the S&P 500 Index and trade in large volume.

Finally, if we desired, we could use options for the hedge as well - say, buying VIX put options that trade on the CBOE and buying listed SPY put options as well.

Let's call this an inter-market spread. When trading inter-market spreads, one has to determine the quantity of derivatives traded on each side of the position. It would not be correct, for example, to merely short one May VIX futures and short one June S&P futures contract. The S&P is far too dominant (the S&P 500 Index is trading at roughly 68 times the value of VIX). The proper ratio in an inter-market hedge is determined with this formula:



In this case,
For June S&P futures (first underlying):
Underlying price = 1365
Shares per contract = 250
Volatility = 22%

For May VIX futures (second underlying):
Underlying price = 22.50
Shares per contract = 1000
Volatility = 105%

Multiplying out the formula, we obtain a ratio of 3.18. In other words, we would short roughly 3 VIX futures for every one short S&P future.

You can work out the various ratios for other products (for example, if you wanted to short SPY ETF's instead of S&P futures, the shares per contract would be 1 and the underlying price would be about 137).

If you want to use options, the shares per contract would be 100 for both sides of the trade. As far as margin requirements go, the options trade requires the least initial margin. There is no cross-margining benefit in the futures margin, even though this is supposedly a hedged trade.

This seems to be a reasonable hedged approach to take advantage of the cases where VIX futures trade at large premiums or discounts to VIX itself. And, as is always the case with a hedge approach, profits would be smaller than an outright speculative position in the S&P 500 Index might be, but the probability of profit should be higher (in theory).

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S&P 500 3-month Variance Futures

Variance is a measure of how spread out a distribution is. It is computed as the average squared deviation of each number from its mean. Squaring the distance from the mean has the effect of giving greater weight to values that are further from the mean. Although the variance is intended to be an overall measure of spread, it can be greatly affected by activity at the tails of a distribution. CBOE S&P 500 3-month Variance Futures are based on the realized, or historical, variance of the S&P 500 Index. CBOE S&P 500 3-month Variance Futures are quoted in terms of variance points, which are defined as realized variance multiplied by 10,000. One variance point is worth $50. For example, a variance calculation of 0.06335 would have a corresponding price quotation in variance points of 633.50, and a contract size of $31,675.00 (633.50 x $50).

Implied and Realized Components of the S&P 500 3-month Variance Futures

Because S&P 500 3-month Variance Futures are based on the realized variance of the S&P 500 Index, the price of the front-month contract can be stated as two distinct components: the realized variance and the implied forward variance. CFE will disseminate both of these values at the end of each trading day under the following tickers:

Realized Variance - RUG: An indication of the realized variance of the S&P 500 Index corresponding to the front-month Variance futures contract.

Implied Forward Variance - IUG: An indication of the future variance of the S&P 500 Index that is implied by the daily settlement price of the front-month Variance futures contract.

Variance futures contracts are forward starting three-month variance swaps. Once a futures contract reaches front-month status, it enters the three-month window during which realized variance is calculated. To calculate the variance, sum the daily returns of the S&P 500 from the swap-start date through futures expiration, then annualize the number. Because the daily returns are additive, on any day, it is possible to know both the realized variance since the first day of the swap period (RUG) and the implied variance of the S&P 500 derived from the price of the variance futures contract (IUG). For example, on March 4, 2005, the front-month Variance futures contract (VT/H5) had 10 business days remaining until settlement. Because the entire three-month swap period encompassed 62 business days, 83% of the contract's settlement value has been realized (RUG). The RUG reported by CFE that evening was 94.97 and the VT/H5 daily settlement price was 99.50. Using the following formula, we can calculate the implied forward variance (IUG) for the remaining ten days.

Where VT is the daily settlement price for the front-month Variance futures contract. RUG is realized variance so far in the life of the contract. T is the total number of business days in the Variance futures. t is the number of business days left until options expiration.

Taking the square root of the IUG, one finds the futures price is implying an annualized S&P 500 return standard deviation or volatility of 11.09% over the next ten days. ). For more information about the S&P 500 Three-Month Variance calculation, please visit the education page for the CFE.

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

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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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*     This is a paid advertisement. The inclusion of these advertisements should not be construed as an endorsement of any product, service, or Web site or as an indication of the value of any claims, recommendations or other information contained therein.

Copyright © 2008 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.

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.