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, 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. 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

Announcements

CFE will be launching event binary contracts, pending final regulatory approval. The CFE Purchase-Only House Price Index (HPI) Binary Option contract and the CFE U.S. Consumer Price Index for All Urban Consumers (CPI-U) Binary Option contract will be the first two contracts introduced. Watch this space for more details or contact the CFE helpdesk.

March 2 marked the launch of Mini Vix futures, "We expect that the mini-VIX futures contract will attract the attention of sophisticated investors and institutions who are looking for a smaller-scale play on implied volatility that's independent of the direction and level of stock prices, or a way to hedge equity returns, diversify portfolios, and spread implied against realized volatility," said CFE Managing Director Andrew Lowenthal. "As seen over the last year, the VIX has experienced some dramatic spikes, and a smaller VIX futures contract with proportionately lower margins may be more manageable for a wider variety of users."

"We look forward to participating in CFE's new mini-VIX futures, as we see the smaller contract as an attractive trading vehicle for the individual investor," said David Graff, Senior Trader at Wolverine Trading, one of the firms that will be making markets when trading begins. "Many of today's very successful mini-contracts have started out as larger contracts and have become just as successful as their larger counterparts."

"An additional benefit," Graff said, "is that VIX options traders now can hedge with a like-sized futures contract, so we expect these traders to be natural participants."

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.

VIX^® Appears Range-Bound

In the last month, the market has moved severely lower and then sharply higher. In neither case did VIX have a large reaction to the market movement. For the most part, VIX has been contained in a range between roughly 38 and 53 for about three months. It did not spike higher when the S&P 500^® Index fell from 930 to 670 in a matter of a few weeks, nor did it spike downward on the reflex rally to a S&P 500 Index level of 800.

Some say these dampened movements of the VIX reflect the fact that the actual volatility of the S&P 500 index has remained subdued, and they may be right. For example, the bulk of the recent decline from 810 down to 670 was so orderly that the historical volatility of the S&P 500 Index only moved up from about 40% to 45%. Thus, option traders apparently did not feel compelled to pay up dramatically for the S&P 500 index options, and hence, the VIX remained subdued as well.

But perhaps things are changing. Just this week, VIX has shown a little more life, as it jumped about 5 points higher when the market declined over the past few days. For the record, March futures settled at 40.62 on settlement Wednesday. Three days later, VIX traded above 47.

Most of the futures contracts have remained at a discount to VIX itself. Table 1 shows the current levels of premium. The near-term April future rose to a premium today, but the others are trading below VIX.

Source: MAC

Term Structure

The term structure describes the relationship between the various futures contracts. As you can see from Table 1, the April contract is trading at the highest price, with May next highest, then June, and so on. This downward sloping pattern typically emerges during a bearish phase in the market. When it stretches too far, it may be symptomatic of an oversold condition, and it typically begins to move the other way, to flatten. However, this structure with the front end elevated has persisted for quite some time in both the S&P 500 Index declines and rallies. Perhaps it is more reflective of the fact that VIX appears stuck in this trading range, than it is of the movements in the S&P 500 Index.

In any case, when it gets too wide, such as when April trades at prices too far above July (the current spread of 5.65 between the two is fairly high), this is generally evidence of an oversold condition and a near-term rally usually springs up, flattening the term structure somewhat.

VIX Futures as a Predictive Tool (Updated)

At the recent CBOE Risk Management Conference in Laguna Niguel, California, there was some discussion that the VIX derivative products had lost their ability to predict movements in the S&P 500 Index. That is not entirely true. What has spurred this sort of thinking is the fact that the VIX did not spike up to a peak and snap back down again when the S&P 500 Index declined sharply into the "V" bottom at 670. Also, discrepancies in the term structure, which at one time resulted in almost immediate movements in the S&P 500 Index, have taken much longer to materialize.

For example, prior to September 2008 (the demarcation line between normal bull and bear markets and the current crisis market), if the VIX futures were at a discount to VIX, there would typically be a good rally in the S&P 500 Index within a matter of a day or two. Conversely, if the VIX futures were trading at a premium to VIX, it would generally not be long before the broad stock market sold off sharply.

Figure 1 shows a scatter diagram of the daily discount or premium on the blended VIX front-month futures. By blended, we mean a smoothing of the two front-month futures contracts, in line with the formula used to calculate VIX. If you do not use the blended futures price or premium, then you may have discontinuities when one contract expires and the next one becomes the front month. "B" for buy has been placed on the graph where large discounts occurred. "S" for sell shows where premiums existed. Anything between the two parallel lines is irrelevant, as the discount or premium in those cases is too small to be considered predictive. From the red line (S&P 500 Index) on the top of the graph, you can see that the buys and sells presaged some very large movements in the broad market.

Notice that, at first, only a few dots below the lowest parallel line constituted a buy signal. But with the crash in September/October 2008, the discounts not only magnified but persisted for quite a while. Finally, when the magnitude of the discounts began to shrink, the market rallied. More recently, notice the series of discounts that began to appear in February 2009, as the stock market collapsed in the wave of selling that took the S&P 500 Index down from 800 to 670. This series also persisted for a large number of days. But when the discounts began to shrink, about 2 weeks ago, the market rallied.

A similar feature can be seen with the sell signals associated with large premiums on the VIX futures. At first, it only took a few dots above the highest parallel line to generate a sell signal. Then as the bear market got more severe, the premiums would build up for a longer time. The one in December 2007 was perhaps the first and most noticeable series. At that time, the S&P 500 index had rallied into Christmas 2007, and traders were expecting positive things from the Santa Claus rally, January Effect, and the like. However, the large premium began to build up on the VIX futures about December 18th and persisted through Christmas. The S&P 500 Index turned south before the end of the year and January was a disaster with the S&P 500 Index falling 200 points in less than a month. That was the first time that the power of a series of premiums or discounts was discernable.

Since then, there have been several series of premiums, all of which were followed by sharp market declines. The most recent was the buildup of premiums from late December 2008 throughout most of January 2009. Once those premiums peaked, the S&P 500 index soon cracked support and went into the free-fall which ended just a couple of weeks ago. One more thing we see from Table 1;: the front month futures are just now edging up to a premium. If this starts to persist, it would likely not bode well for the broad stock market.

In summary, it is evident that the VIX futures blended front-month premium is still a valuable guide to the fortunes of the broad market, as measured by the S&P 500 Index. A series of large premiums is typically a bearish warning, while a series of large discounts is typically bullish. Keep that in mind as you try to guide yourself through the treacherous waters of this bear market.

Figure 1                                               Source: McMillan Analysis Corp.

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 © 2009 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.