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

CFE will begin publishing an index value based on Implied Correlations, starting Tuesday June 3rd. Watch for the Press Release and soon to be launched web page.

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.

Near-Record Premium Levels

Volatility has declined in the last month. However, not all derivatives have declined as much as the spot VIX Index. As a result, the VIX futures currently are trading with some of the largest premiums since the futures were listed over four years ago.

The recent decline in the VIX has accompanied a general rise in the market (i.e., S&P 500 Index ("SPX")). That's nothing unusual, of course. Refer to Figure 1 below. The green line is the VIX itself, while the colored lines are various VIX futures contracts. The current action is on the far right-hand side of the graph. Note that all the lines are dropping - indicating a general decline in volatility in all the derivatives. However, only the yellow line (May VIX futures) declined as sharply as the VIX. And that was only due to the fact that the May futures expired this week (May 21st). Prior to that, the May VIX futures were even holding a rather large premium.

Figure 1 Source: McMillan Analysis Corp.

The other VIX futures have not followed the VIX down nearly as fast. The large difference between the green line and the colored lines is the futures premium. Table 1 shows the current premium levels, using settlement prices from May 22nd.

Ostensibly, this large premium has negative connotations for the stock market. The last time that large premiums (although not this large) existed was in late December, 2007. After large premiums persisted for about three weeks, the stock market declined sharply in January, 2008

The current spate of large premiums has persisted for even longer than that. Could some sort of semi-permanent change in the relationships between the VIX and its derivatives have taken place? It seems unlikely, but there is one possible scenario that could be plausible.

Recall that when VIX futures were first listed, the VIX traded at low prices between 10 and 14, in general. At those times, VIX futures traded with large premiums because traders rightfully viewed the VIX as being at a bottom (since it has never traded below 10 for any length of time). The only way that the current levels of high premium could be justified - and not be a bearish predictor -- would be if traders were viewing the current levels of the VIX as a floor of sorts. This seems unlikely, though, as it's much more likely that the large premium levels fall into the category of "the futures are always right," meaning the VIX will eventually rise to equal the futures (and the stock market would thus decline - probably sharply).

In summary, these large premiums are likely a bearish predictor, except in the unlikely event that traders view VIX levels of 17-18 as a new "floor" on the VIX.

The Term Structure Of Futures Prices

We often talk about the relationship of the futures prices to the VIX itself, but sophisticated traders also keep an eye on the relationship of the futures contracts to each other. It's somewhat akin to bond traders watching the yield curve.

For example, the data in Table 1 shows the current futures prices (as well as the VIX, at the time, which was 18.05). If one were to plot this data, there would be a distinct shape to the curve that the data describes. Figure 2 is the graph of the current term structure (as of May 22nd) - using the data from Table 1.

The term structure curve can be quite illustrative when at extremes. Furthermore, if one constantly observes the shape of the curve, its movements from one shape to another can help as a market predictor. As an example, Figure 3 below is a snapshot of the term structure at three different points in September and October of 2007.

Figure 2 Source: McMillan Analysis Corp.

If you'll recall, the market took a beating in August 2007, but was trying to rally in September. SPX was bumping up against resistance at 1500. But the VIX was higher than all of the futures contracts at that time - the top curve in Figure 3. This is a bullish construct, as the curve is overextended to the upside. The futures are "predicting" that the VIX will fall (i.e., the market will rise). SPX was at 1476 at the time.

It did break out and a week later, with SPX at 1516, the futures term structure had flattened out (middle curve in Figure 3 - green triangles). When the curve moves in that direction, from "high" to "flat," it is bullish for the market. It continued to move in the same direction, reaching an extreme on Oct 5th, with SPX at 1557. By that time, the VIX was lower than the futures (as it is now), and that preceded a bearish market move.

So, the term structure of futures is important, especially when one keeps track of it and can denote whether the curve is flattening or steepening at any point in time. Note the contrast between the current situation (Fig 2) and that of last fall (Fig 3, top curve). The current structure is not bullish, and in fact will be bearish once the curve starts to flatten.

Figure 3 Source: McMillan Analysis Corp.

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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.