CBOE Futures Exchange

September 28, 2012, Volume 6, Issue 09


A CFE Newsletter focused on Volatility Futures

Volatility Newsletter

VIX Futures Last Trade Dates

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Contract Last Trade Date
October 2012 10/16/2012
November 2012 11/20/2012
December 2012 12/18/2012
January 2013 01/15/2013
February 2013 02/12/2013
March 2013 03/19/2013
April 2013 04/16/2013
May 2013 05/21/2013
June 2013 06/18/2013


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VIX Futures Single-Day Volume Record Set on Thursday, September 13th

Brodsky At CBOE Risk Management European Conference: Announces Plans For 24-Hour VIX Futures Trading And CFE London Hub

CBOE Futures Exchange And DRW Trading Group Complete Agreement To Create Stock Index Variance Futures.  

A CBOE Community Blog
Whats on Our Minds: Read the CBOE Blogs

Market Summary & Analysis

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Market Summary and Analysis is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation.

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Volatility remains at low levels

The CBOE Volatility Index® (VIX®) continues to trend lower, trading below 14 in recent days. While it has not broken yearly lows that were set in mid-August it is still at extremely low levels when compared to historic levels. The S&P 500 Index (S&P 500) has made new post-2007 highs several times in recent weeks, so it is logical to expect that VIX will follow suit and make new lows. The two indices, S&P 500 and VIX, tend to move in opposite directions. There are periods of these inverse moves not occurring, such as we are seeing now, but they are generally rather short-lived.

The VIX settlement value fell to 14.03 in September. This is the lowest settlement since June 2007. Other volatility indices have followed suit and are at their lowest levels since June 2007. Five years ago volatility was on its way up after having spent considerable time at extremely low levels during 2005 and 2006. In July 2007, the world first learned of the problems with "subprime debt," and volatility soon thereafter was headed to much higher levels. Currently volatility is trending lower, so the fact that it is at the same levels of June 2007 is likely nothing more than a coincidence. The fundamental and technical backgrounds were much more bearish in 2007 then than they are now. Simply stated, in 2007 we were exiting a long period of complacency, while today we just might be in the early stages of one.

Figure 1 Source: McMillan Analysis Corp

Figure 1 shows the entire history of the monthly VIX settlement prices, since the inception of futures trading in May 2004 (trading first began in March, 2004, and the first contracts that settled were the May, 2004, futures). The symbol for the monthly settlement price is VRO. The S&P 500 Index is also overlaid on the graph. While there is not a perfect (inverse) correlation between the S&P 500 and VRO (and, by inference, VIX), one can see the general tendency of the two to move in opposite directions.

Some are saying VIX is so low that it represents major complacency amongst traders and investors, and that a major market correction may be at hand. That may not be the case at all. First, VIX remains in a downtrend, which may be a bullish sign for stocks in general. Absolute levels of VIX are historically low, since it is near 14, but there have been other times when VIX traded well below 14 while the stock market continued to rise for an extended period of time. The most recent time that occurred was in 2006.

Also, it should be pointed out that the actual (realized) level of S&P 500 20-day historic volatility is at 11% now. Therefore, it is not unusual to see VIX at 14 with realized volatility at 11. The trend of realized volatility has been decreasing, so it is reasonable to expect that VIX will remain at these relatively low levels as long as realized volatility continues to be subdued.

Premium and Term Structure

There continues to be a huge appetite for volatility derivatives. This continues to make the term structure of the VIX futures contract very steep and the premium on each futures contract quite large.

Table 1 shows the state of the VIX futures term structure on September 21st. These are large premiums, although not at the record levels we have seen other times this year. The near-term, front-month October futures are carrying a premium of 2.07. The premiums expand quickly as one looks farther out along the time spectrum. November futures have a premium of 3.92, December 5.27, and so forth. The longest-term, May 2013, futures trade with a premium of 11.27 points, which is quite large.

The relationship of the futures prices at different maturities is known as the term structure, and you can see that, currently, it slopes steeply upward. In normal times, these large premiums on the futures, coupled with a steep positive slope to the term structure, would be considered very bullish. However, in the current environment, where the "protection trade" is still being heavily implemented, utilization of VIX futures is a result of that hedged trader's activity, more than it is a predictor of forthcoming market movement. The "protection trade" essentially consists of institutional traders buying the S&P 500 (or the equivalent) and also buying the iPath S&P 500 VIX Short Term Futures ETN (VXX or the "volatility ETN").


With VIX at low levels and with certain market indicators ostensibly overbought, one might think that the stock market is due for a sharp correction and/or VIX is due for a sharp rally. That would be a speculative position of course, and one could easily implement that opinion merely by buying near-term VIX futures.

Since last Thanksgiving, the market has not undergone many corrections and most of those have just been sideways moves, which allow overbought conditions to abate. The only significant correction occurred last May and even then it was rather short-lived.

So, we are still in favor of the hedged strategy of buying puts on both SPX and VIX futures. This is more akin to owning a straddle on the stock market: if the S&P 500 declines, the SPX puts will profit and the VIX puts have limited risk. If the S&P 500 advances, the VIX puts should profit as VIX futures drop to meet VIX (at least they will at expiration), while the SPX puts can only lose a fixed amount.

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Volatility and Volatility Index Security Futures

The article below is provided by Michael McCarty. Mr. McCarty is the founding member and chief strategist of Differential Research.

Volatility Index and Volatility Index Security Futures set several records this month. The first and potentially best known was the September CBOE Volatility Index® (VIX) future settlement value of $14.03; the lowest final settlement value in VIX futures since June 2007.

Sources: CFE, Differential Research, LLC

VIX futures set further milestones with record open interest of 431,265 contracts on September 18th and record trading volume of 190,081 contracts on September 13th.

Sources: CFE, Differential Research, LLC

The September settlement value for the recently launched CBOE Nasdaq-100 Volatility Index Future (VN) was $15.11, the lowest in its three month settlement history of 2012. The CBOE Brazil ETF Volatility Index Security Future (VXEW) also had the lowest settlement value of $26.62, since its launch this past April.

Sources: CFE, Differential Research, LLC

With implied volatility for the series of six asset classes currently represented by tradable futures/security futures falling for much of their life, contract highs were generally set at or near their first settlements while contract lows were set at or near expiration.

Sources: CFE, Differential Research, LLC

Sources: CFE, Differential Research, LLC

While the price charts visually suggest a high degree of correlation for the group, the CBOE Oil ETF Volatility Security Future (OV) declined the least.

Sources: CFE, Differential Research, LLC

While the existence of an overall general trend would seem to confirm the thesis of "risk-on/risk-off", the unique patterns suggest that perceptions of risk are more nuanced providing an intellectual underpinning for the pursuit of inter-volatility market arbitrage opportunities.

Sources: CFE, Differential Research, LLC

As volatility futures/security futures volumes continue to grow, we look at the relative relationships seeking to better define, quantify and ultimately capitalize on inter-market volatility arbitrage opportunities.

The September CBOE Gold ETF Volatility Index Security Future (GV) managed to begin life at a discount to the September VIX future before moving to a premium at expiration.

Sources: CFE, Differential Research, LLC

While the September VIX future's volume increased steadily through expiration peaking on September 13th with 63,251 contracts changing hands, the September contract open interest peaked at 184,949 on August 21, 2012 just as it ascended to the front month position.

Sources: CFE, Differential Research, LLC

September's VXN future, the most recently launched volatility index future, generated some initial interest late in the contract's life.

Sources: CFE, Differential Research, LLC

The September OV security future proved to be the most popular volatility index security future with a peak volume of 1,000 contracts.

Sources: CFE, Differential Research, LLC

The September CBOE Emerging Markets ETF Volatility Index Security Future (VXEW) was the second most popular September security future.

Sources: CFE, Differential Research, LLC

The GV Security Future has recently begun to generate investor interest.

Sources: CFE, Differential Research, LLC

It would appear that the trading of the VXEW September security future involved one position initiated and later closed.

Sources: CFE, Differential Research, LLC

Finally, one important consideration for anyone considering establishing a relative value strategy in volatility futures/security futures is contract size. For VIX and VXN Index futures the multiplier is $1,000 while the multiplier for volatility index security futures is $100.

VIX Trading Strategies

By Mark Shore, Founder of Shore Capital Management.

In the May 2012 newsletter article "Volatility Futures: Relative Strength: A Family of Futures Products", we discussed various methods of trading volatility futures products as spreads or indicators, with some discussion of their basic characteristics. This article will provide discussion of trading methods for individual volatility futures products. The CBOE Volatility Index® (VIX®) futures contract tends to be mean-reverting and trades within a range bound market. Excluding the 2008 financial crisis, the VIX level tends to fluctuate between 40 and 10. For liquidity seeking traders, hedgers or managers, the chart below demonstrates the increasing volume and open interest in VIX futures, making it a viable choice for a liquid portfolio.

VIX futures trading volume recently reached a new high on three fronts:

1) In August 2012, the VIX futures average daily volume increased by 4.6% to 83,016 contracts versus August 2011 volume of 79,402 contracts.

2) The total volume year to date trading volume in VIX futures has increased by 59% to 13.7 million contracts versus January through August of 2011 volume of 8.6 million contracts.

3) On September 13, 2012 the VIX futures contract reached a new single-day volume record of 190,081 contracts traded. The previous record was 159,744 contracts traded on June 8, 2012.

In a range bound market, long term directional trading may not work as well as it would in other futures markets. Overbought and oversold indicators may have greater utility value. However in the shorter term (duration of days and weeks), directional trades may offer some value.

Chart 1: Monthly nearest VIX futures chart

Sources: www.barchart.com

Prior to the 2008 financial crisis, VIX levels fluctuated in tighter ranges between 10 and 20. Post the 2008 financial crisis, trading ranges narrowed but yet are still wider than those prior to 2008. Could this be the "new normal" range for the VIX?

Chart 2: The weekly nearest futures chart below shows the VIX since the end of 2008.

Sources: www.barchart.com

For this discussion of trading strategies, we looked at two very simple and common methods of technical analysis for support/resistance and trend identification: 1) Seeking contrarian changes at range bound extremes, and 2) Crossing of moving averages. For the first method, the previous two charts show on a monthly and weekly basis a common major resistance around 35 to 40. This knowledge could be used for risk management to either close or reduce the size of a long position or to search for the timing to enter a short position when the market nears resistance at 40. Just the opposite is implied when the market reaches a common major support of 10 to 15. For risk management purposes, an investor could reduce or exit a short position as the market nears this support level. Or an investor could seek the timing to find a new long position to enter.

The second method utilizes a simple moving average crossover of 5 (green) and 20 (red) to identify either the end of a trend or the beginning of a new one. In Chart 2 we applied a 5 & 20 week simple moving average crossover strategy. The 5 week average crossed below the 20 week average in January 2009 and began to signal a possible short position. This could also be coupled with the fact that it was above 40 and was already in an extreme price range. However at that time, the markets were very nervous as the economy was in the midst of a financial crisis as noted in the high volatility and one has to take into account of the VIX drifting lower from its all-time high.

Moving forward the market remained in a downward bias until April 2010 when it based around 17. In May of 2010, the averages crossed again to indicate a possible long direction or at least an end to the short bias. Soon after, the VIX futures reached major resistance around 40 and then reversed. In 2011 and 2012, similar situations occurred of the averages crossing for possible signals and the market reaching major support and resistance levels.

The above discussion creates a background and now we can now move the concept to daily data.

Chart 3: Daily nearest futures VIX chart for the past 12 months ending September 14, 2012.

Sources: www.barchart.com

We find a similar experience on the daily chart as we found on the weekly chart. In the beginning of October 2011, the market was at a major resistance point above 40. Soon after, the VIX fell and appeared to have received a crossover signal for a short bias. In November the signal appears to have been reversed and a few weeks later another short signal appeared. By March 2012 the market was building a base around 16. Between March and September the market tended to rally from the major support level near the 15 to 16 range.

Next we to take this idea one step further to individual daily data in Chart 4. Will the crossover and support/ resistance methods still hold? The crossover method continues to show an ability to add value in determining direction. The market continues to move lower since June when it was 30 and now nearing a major support level on Sept 14, 2012. Is this another moment of base building near the major support level and a possible reversal of the VIX? If it should rally from this point, that could imply increase volatility for the S&P 500.

Chart 4: Daily data basis the October 2012 VIX futures contract ending Sept 14, 2012.

Sources: www.barchart.com

In summary, we discussed two common and simple trading methods that may be applied to trade the VIX futures contract??? on a daily or weekly chart. Future articles discuss other trading strategies for volatility products. This article is not intended to recommend a specific trading strategy, but to educate the reader on some ideas to investigate beyond spreads or hedging of volatility futures.

If you have a favorite volatility futures trading strategy you would like to share, please send email to: info@shorecapmgmt.com


Please direct questions concerning this circular to:

Jay Caauwe

Jennifer Fortino

About Larry McMillan and McMillan Analysis Corporation
Lawrence McMillan is the recipient of the Sullivan Award for 2011, awarded by the Options Industry Council in recognition of his contributions to the Options Industry. 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.

About Michael McCarty
Michael McCarty is the founding member and chief strategist of Differential Research. An independent provider of derivative research for institutional investors. Differential Research was founded to capitalize on the growing importance of risk and volatility analysis in the investment process. Mr. McCarty is a frequent guest on BloombergTV, Fox Business News and CNBC, in addition to being quoted regularly by the financial press. Mr. McCarty also speaks frequently on the topics of risk and volatility at investment industry conferences.

Michael McCarty was formerly the Chief Strategist at Meridian Equity Partners, an independent broker dealer. As director of the firm's Option Market Operations, Mr. McCarty published two widely-read notes per day, targeting on the US marketplace and uncovering Noteworthy Option Activity.

Born in the Republic of Panama and raised in Central Florida, Mr. McCarty's fascination with the financial markets came early on, first studying finance and history at Emory University, then obtaining a Masters Degree in Finance from New York City's Baruch College – Zicklin School of Business. His vast knowledge and deep understanding of the equity and derivative markets, the result of a twenty-five year Wall Street career as sales-trader, analyst and market strategist has allowed him to accumulate a significant following of the most respected and accomplished investors worldwide.

About Mark Shore
Mark Shore has more than 20 years of investment, research and futures experience. In 2008 he founded Shore Capital Management LLC where he consults in alternative investments regarding due diligence, research, educational workshops and business development. He is a frequent speaker at alternative investment events. He has published several papers on alternative investments and asset allocation. His research is found at www.shorecapmgmt.com.

Mr. Shore is an Adjunct Professor at DePaul University's Kellstadt Graduate School of Business where he teaches a graduate level managed futures/ global macro course. He is also an Adjunct Instructor at the New York Institute of Finance and a Contributing Writer for Reuters HedgeWorld and the CBOE Futures Exchange. Prior to founding Shore Capital, Mr. Shore was Head of Risk for Octane Research Inc ($1.1 billion AUM) in NYC from 2007 to 2008, where he was responsible for quantitative risk management analysis and due diligence of Fund of Funds. He chaired the Risk Management Committee and was a voting member of the Investment Committee.

Prior to joining Octane, he was at VK Capital Inc from 1997 to 2006, a wholly owned Commodity Trading Advisor ($250 million AUM) of Morgan Stanley. As Chief Operating Officer of VK Capital, Mr. Shore provided research and risk management expertise on portfolio issues, product development and business strategy. Mr. Shore graduated from DePaul University with a degree in Finance. He received his MBA from the University of Chicago.

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.

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