CBOE Futures Exchange

October 31, 2012 Volume 6 Issue 10


A CFE Newsletter focused on Volatility Futures

Volatility Newsletter

VIX Futures Last Trade Dates

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Contract Last Trade Date
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
July 2013 07/16/2013


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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.  

Visit us at the FIA Futures and Options Expo at the Chicago Hilton, October 31-November 1st.
Click here for more details

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 starting to edge higher

The CBOE Volatility Index® (VIX®) has moved up to the high end of its recent trading range, from roughly 13.50 to 17. A breakout move above 17 would carry a more bearish sign for the S&P 500 Index (S&P 500) and the stock market in general. The sideways trading range of VIX over the past month and a half means the downtrend of VIX has been broken, but it is still not in an uptrend, which would be bearish for stocks.

Looking back through August, VIX has not been higher than 19, so a rise in VIX to 19 would not be devastating. However, a VIX close above 19 would be regarded as bearish for stocks. When VIX is trending higher, stocks are generally trending lower.

In October the VIX settlement value rose to 15.96, a relatively low level when looking at the entire history of VIX settlements (See Figure 1). However, it is the highest settlement in three months.

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 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.

Figure 1 Source: McMillan Analysis Corp

Last month we compared VIX to historical volatility and we will compare it once again. The 20-day historical volatility of the S&P 500 fell as low as 8% earlier in October and now it is at 11%. VIX trading between 13.50 and 17 does not really represent a "cheap" VIX. When VIX trades at a rather substantial premium to actual volatility VIX is at low levels.

One should note that when S&P 500 historical volatility reaches levels below 10% often times that indicates volatile moves by the index over the next six months. Often, that move is to the downside.

In any case, it seems that if VIX were to rise above 19 and/or the 20-day historical volatility of S&P 500 rises above 15%, either or both would carry bearish signals for S&P 500 and stocks in general.

Premium and Term Structure

The "protection trade," as I like to call it, continues to be popular with institutions. They are buying S&P 500 options (SPX options) (or any other equivalent broad-based portfolio of large-cap stocks) while also buying volatility protection. Volatility protection is either directly in the form of VIX futures or in the form of exchange traded notes (ETNs) and exchange traded funds (ETFs) tracking volatility. Those ETNs and ETFs buy VIX futures, so one way or the other, the "protection trade" is believed to be largely responsible for the continued steepness in the VIX futures term structure.

Table 1 shows the state of the VIX futures term structure on October 19th. There has been a considerable change in this picture. First, the futures have far less premium across the board. Just a month ago, some of the longer-term futures had premium in excess of 11 points, and the November futures had a premium of about 4 points. That is no longer the case. In fact, November futures are likely to trade at a discount if VIX continues to rise in coming days.

The relationship of the futures prices to each other is the term structure and it slopes steeply upward yet not as steep as it has been in recent months. Even so, June futures are trading about 7 points higher than November futures, which is a substantial differential. As we noted above, this is partly due to the heavy demand for volatility protection coming from institutional investors. It is also natural for the term structure to slope upward when VIX is trading at low prices.


With the VIX futures losing some of their premium, one might consider the prospect of either buying VIX futures outright or setting up a hedged trade. If one buys the VIX futures outright, then he profits if volatility increases.

In a hedged trade, one would buy VIX futures and also SPX options. In the hedged scenario if the stock market rose, one's long VIX futures position would likely lose money, but the hedge would gain.

Another implementation of the hedged trade is to buy call options on both SPX options and VIX. In the case of SPX options, the proper ratio would be to buy about 20 at-the-money VIX calls for each at-the-money SPX call purchased, in order to produce a neutral hedge. This is somewhat akin to owning a straddle on the stock market, except that one "leg" is volatility. If the stock market rises, the SPX calls profit (VIX puts have limited risk); if the stock market falls, VIX should rise and those calls would profit (SPX calls have limited risk). So, the greater the stock market moves, the better the likely outcome for the hedged option trade.

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Volatility Index 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.

As trading volume grows for volatility index and volatility index security futures outside of the popular CBOE Volatility Index® (VIX®) futures, investors will increasingly be able to hedge specific ¬portfolio risks. While a pure equity portfolio highly correlated with the S&P 500 Index (S&P 500) may be content hedging with VIX futures, a technology portfolio for example may find the CBOE Nasdaq-100 Volatility Index (VXN) future a better vehicle. Likewise an emerging market portfolio may find CBOE Emerging Markets ETF Volatility Index (VXEEM) security future more negatively correlated and therefore a better hedge.

As these markets continue to develop, different assets' implied volatilities will increasingly present arbitrage opportunities. For example, as Apple Computer is highly weighted in the NASDAQ 100 Index (NDQ), its implied volatility is a significant factor in the value of the VXN index and the price of VXN futures. Consequently, there may be opportunities to trade the difference between the price of VIX and VXN futures.

While we will look at the differences between futures prices shortly, given the longer history for the calculated indexes' values, we will look at the historical relationships first for a slightly longer term perspective. However, first a quick refresher on the differences between broad based volatility indexes, exchange-traded fund (ETF) based volatility indexes and futures and security futures. First the indexes are calculated using the mid-point between the bid and ask price of two series of CBOE-listed options for the underlying index, except at the moment of expiration when only one series is used. The two series are weighted to arrive at a thirty-day average term. At expiration the opening prices are used. The future value therefore is essentially the market's estimate of what the value will be at expiration, while the index is an estimate of what the value would be if expiration occurred at that moment. At expiration the two values converge, although they will likely differ given the difference between actual trade prices and mid-points.

First we will look at the period with data available for all of the broad based volatility indexes and ETF based volatility indexes beginning April 13, 2011. For comparison purposes we will use the VIX index as our reference, and look at the spreads in relation to the VIX index.

Sources: CFE, Yahoo Finance, Differential Research, LLC

From the graph above we can see that each index demonstrates unique behavior, confirming our thesis of potential arbitrage opportunities.

Sources: CFE, Yahoo Finance, Differential Research, LLC

As would be expected the difference between the VIX and VXN indexes show the least variation, while the CBOE Crude Oil ETF Volatility Index (OVX) has demonstrated the greatest range versus the VIX Index for the period.

Sources: CFE, Yahoo Finance, Differential Research, LLC

Looking at the past year shows similar results.

Sources: CFE, Yahoo Finance, Differential Research, LLC

The unique characteristics of the different indexes are more apparent when viewed up-close.

Sources: CFE, Yahoo Finance, Differential Research, LLC

Once again it is clear that oil ETF volatility as represented by the OVX index has demonstrated the greatest range when compared to the VIX index.

Sources: CFE, Yahoo Finance, Differential Research, LLC

Sources: CFE, Differential Research, LLC

Turning our gaze to the October volatility index futures and security futures that recently expired, we see that daily settlement highs and lows were not set simultaneously.

Sources: CFE, Differential Research, LLC

While the price charts visually suggest a high degree of correlation for the group, the OV security future 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

Sources: CFE, Differential Research, LLC

And while futures and indexes differ, we can see that the October futures reflect some of the same differences and similarities as the underlying indexes. Specifically the spread between the October OV security futures and the October VIX future rose in general over the period.

Sources: CFE, Differential Research, LLC

Looking at each future individually, we see the October VIX index future fell for much of its life. As we have witnessed over the past several months open interest and trading volume in the VIX future increased steadily while the second serial future peaked as it ascended to the front month and fell through expiration.

Sources: CFE, Differential Research, LLC

The October VXN future in turn saw volume and open interest climb and fall before and after the release of Apple Computer's earnings.

Sources: CFE, Differential Research, LLC

The October OV security future notably maintained its value for most of its term.

Sources: CFE, Differential Research, LLC

Sources: CFE, Differential Research, LLC

Sources: CFE, Differential Research, LLC

Finally, one important consideration for anyone considering establishing an arbitrage position in volatility futures is contract size. For VIX and VXN futures the multiplier is $1,000 while the multiplier for volatility index security futures is $100.

Trading VIX Futures with the Aroon Oscillator

By Mark Shore, Founder of Shore Capital Management.

In the September 2012 newsletter, the article "VIX Trading Strategies" was the first in a series discussing various technical and quantitative trading strategies beginning with a simple moving average approach to trading the CBOE Volatility Index (VIX) VIX futures contract. This article discusses the use of the Aroon Oscillator.

The VIX futures contract tends to be mean-reverting, thus seeking overbought conditions is a logical approach to trading this market. As we noted in the previous article, VIX futures tends to trade between a major resistance near 40 and a major support of 10 to 15, and within that the market may trend.

Developing trading strategies involves the investigation of a market's liquidity for various reasons, including the potential for slippage. On October 1, 2012, CBOE Futures Exchange, LLC (CFE) once again reported record volume in VIX futures. In September 2012 the Average Daily Volume reached a new record of 126,345 contracts versus the previous record of 102,587 contracts traded in June 2012. A new record was set in September 2012 of 2,400,552 contracts traded surpassing the previous record of 2,154,325 contracts traded in June 2012. i

For those not familiar with the Aroon Oscillator, it was developed by Tushar Chande in 1995. The oscillator first appeared in the September 1995 issue of Technical Analysis of Stocks and Commodities magazine. The word "Aroon" is Sanskrit for "dawn's early light", thus seeking changes in a market. The oscillator is the differential between the Aroon Up and the Aroon Down indicators which creates an oscillator indicating a market's strength in a trading range.

It is defined as an oscillator because it ranges between defined boundaries of +100 and -100. The value of zero is usually a weak trend. The more the value moves away from zero the greater the probability of either an upward or downward trend occurs. As the value reaches +100 or -100, an indication of overbought or oversold may be in process. The Aroon Up and the Aroon Down indicators calculate the percentage of time since the beginning of the period (in this article a period of 20 days is utilized) that occurred to reach the highest or lowest price in that given period. ii

Chart 1: Monthly Nearest VIX Futures Chart with a 20 Month Aroon Oscillator

Sources: www.barchart.com

For an investor seeking a broader or historical picture of the VIX futures regarding the Aroon Oscillator, the above monthly chart points out moments when the oscillator reaches periods of overbought or oversold conditions. From July 2007 the oscillator moved above zero and eventually to 100 by October of 2008. In early 2009, the oscillator moved closer to zero implying the upward trend was decaying.

Chart 2: Weekly Nearest VIX Futures Chart with a 20 Week Aroon Oscillator

Sources: www.barchart.com

In the 20 week Aroon oscillator, as shown in the above chart, there are moments of overbought and oversold conditions over the 5 year period that converge at major support (15) and resistance (40) ranges of the VIX. Between January 28th and March 3rd of 2008, Aroon was implying the rally was stalling at an Aroon value of 75. Between September 8th and September 15th 2008, the oscillator was signaling a possible breakout move when VIX was at 24.74. On October 13th the market hit a high of 69.40 and a closed at 63.2, simultaneously Aroon reached 100. It is possible the value could have kept bouncing off of 100 if the market moved higher, similar to the oscillator bouncing off of -100 between June 8th, 2009 and March 22nd, 2010.

During the 5 year period, Aroon tends to bounce off of the -100 value several times as VIX futures decline, but quick spikes to 100 and the market reaches resistance during rallies. Between October 3rd and October 25th 2011, Aroon was sustained at 90 and soon after moved lower as the rally of VIX futures decayed. The overbought moment converged at a major resistance point when VIX futures pushed above 40.

Chart 3: Daily Nearest VIX Futures Chart with a 20 Day Aroon Oscillator

Sources: www.barchart.com

The daily chart is similar to the weekly chart spiking at 100 when VIX futures rallies hovered more often around -100 in the selloffs. In November of 2011, Aroon indicated the market topped and a possible downward trend developed into early 2012. On June 1st Aroon peaked at 100 and reached -100 by July 3rd. Since then the market has been choppy with some trading range rallies.

Chart 4: Daily November 2012 VIX Futures Contract with 20 Day Aroon Oscillator. Ending October 19th, 2012

Sources: www.barchart.com

The November 2012 VIX futures contract above suggests that the market is in a downward biased environment. On October 5th, Aroon reached -100 and currently stands at -80. Could this indicate a bottoming formation in the VIX futures and a possible rally later this year or early next year? Would a VIX futures rally imply the S&P 500 Index is in a topping formation and near a correction?

In summary, the Aroon Oscillator may be considered a less lagging indicator than moving averages and closer to a leading indicator for changes in the VIX futures market. The Aroon Oscillator offers investors and Commodity Trading Advisors an interesting approach to explore trading VIX futures.

This article is not intended to recommend a specific trading strategy, but to educate the reader on various strategy 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 email: 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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