By Mark Shore, Founder of Shore Capital Management, April 20, 2012
Many investors are familiar with the CBOE Volatility Index (VIX) that is calculated based on options on the S&P 500 Index option and is an indicator of implied volatility and investor sentiment. But some may not be aware that CBOE Futures ExchangeSM (CFE) lists and trades the VIX futures contract (Ticker symbol: VX).
The popularity of the VX futures contract has grown and the VX futures contract recently experienced its highest trading volume month in March 2012 with 1.96 million contracts traded, which is an 84% increase from a year earlier.i
As the popularity of the VX futures contract increases, CFE continues to expand the volatility index franchise to include futures and security futures contracts covering several underlying markets. See the table below for a list of the volatility index futures and security futures that CFE currently offers for trading on its market.
From the retail investor to the institutional investor or money manager such as a Commodity Trading Advisor or hedge fund, there is always the question: "How can an investor utilize these contracts in a portfolio?"
There are three components to this answer: 1) The contracts traded on CFE have standard trading hours, trade on a quality exchange, offer price discovery, provide marked-to-market transparency, provide liquidity, have margins and are subject to regulations. 2) The contracts traded on CFE futures may be utilized relative to the underlying market to increase or decrease volatility exposure. 3) The contracts traded on CFE may be utilized relative to the other CFE contracts, in essence creating a spread among the different CFE products.
An example of relative strength would be that the VX futures contract tends to move higher when the S&P 500 Index is selling (the negative volatility increases). The correlation of the VIX to the SP is -0.87.ii
Holding long positions in VX futures could offer both potential tail risk protection and a potential reduction of correlation risk. An investor could also play the VX future on the short side, if they believe the underlying market will rally.
On this same theme, if an investor analyzes volatility of the Brazilian equity market, they could employ the CBOE Brazil ETF Volatility Index Security Futures contract (VXEW). The calculation of the VXEW is derived from the VIX methodology applied to options on the iShares MSCI Brazil Index fund (EWZ) listed on Chicago Board Options Exchange, Incorporated (CBOE). These options were ranked the 17th most actively traded exchanged-traded fund (ETF) options in the U.S. in 2011 as noted CBOE.iii One should keep in mind the growing demand for Brazilian investments as Brazil is the "B" of the "BRIC" emerging market economies.
If an investor believes the Brazilian equity market may fall or the potential for tail risk and volatility may increase, then holding a long position in VXEW may offer a risk management technique with the potential reduction of volatility of the exposure of holding the Brazilian investment.
The VXEW may also offer potential reward as a directional play if the investor does not have exposure to the Brazilian market or they are seeking global macro strategies, for example in a managed futures portfolio or a hedge fund portfolio.
On a relative basis, an investor could also spread the VX futures contract against the VXEW security futures contract to seek an increase or decrease of relative strength between the two markets. Chart 1 below shows a 30-day historical volatility of the past 11 years for the iShares MSCI Brazilian index and the S&P 500 Index and for potential spreading opportunities.
Since the financial crisis, there appears to be an increased correlation of 30-day volatility between the U.S and Brazilian markets. The volatility of the S&P 500 tends to remain in the lower range of the Brazilian volatility.
This method of relative strength trading may not immediately appear obvious, but a deeper exploration of the "natural" spreads between the indices could be considered one more tool in a portfolio's toolkit for either risk management purposes or directional trading.
While we are on the discussion of emerging markets, the CBOE Emerging Markets ETF Volatility Index Security Futures (VXEMSM) traded on the CFE allows an investor to employ this contract for possible protection from emerging market volatility risk or as a directional trade. The VIX calculation methodology is applied to CBOE listed options on the iShares MSCI Emerging Markets ETF to derive a measure of implied volatility.
Returning to the idea of relative strength between the volatility indices, Chart 2 below demonstrates the correlation between the Emerging Market Volatility spot market (VXEEM) and the S&P 500 VIX futures spot market, thus allowing for possible spreading opportunities between these contracts. Over the past year, there appears to be a tendency of a correlation between the two markets, thus seeking opportunities when the spread becomes too large or too narrow.
An investor may also find volatility indices for commodities at the CFE. In March of 2011 the CFE added the CBOE Gold ETF Volatility Index (GVSM) Security Futures contract and the CBOE Crude Oil ETF Volatility (OVSM) Index Security Futures in March 2012.
The GV is derived from VIX methodology applied to options of the SPDR Gold Trust (GLD). The OV futures contract is derived from the VIX methodology applied to options of the United States Oil Fund (USO).
As gold and oil are considered indicators of inflation, growth or contraction of an economy or their pricing relationship to the U.S. dollar, the gold and oil ETF volatility index security futures contracts may add value as implied indicators of their underlying markets for risk protection, directional trading or as spreads against each other and against equity markets.
Chart 3 below demonstrates the volatility of the gold, oil and S&P 500 spot markets over the past 19 years. Oil has maintained a higher baseline of volatility. When oil is near the bottom of the baseline in the low 30s to low 20s it offers a potential spreading or directional opportunity for volatility futures. That same baseline is often considered a mid to upper level range for the S&P 500 and gold as noted in Chart 3 and could be advantageous in determining a spreading or directional opportunity.
As of 2011, Brazil was the 11th largest producer of oil and could be in the top five of oil producing nations by 2020.iv This may result in Brazil changing from being an oil importer to an oil exporter impacting their economy. As Brazil increases its oil production in the future, this may allow for a stronger interaction between the oil market and the Brazilian economy, thus employing an OV/VXEW spreading strategy. This is a trading strategy to keep a lookout for in the future.
Chart 4 below is an example of the recent volatility of the Brazilian and oil ETFs.
In summary, investors have choices of strategies to utilize the growing product list of CFE volatility indices. These include utilizing the volatility indices for possible tail risk reduction, directional trading or relative strength spreading among the volatility product indices.
i "March is Record Setting Month at CBOE Futures Exchange", April 2, 2012. Press Release.
ii Moran, M. 2012. "Managing Brazilian Volatility with Futures and Options on the VXEWZ Index", Feb. 17, 2012. http://www.spvixviews.com/2012/02/17/managing-brazilian-volatility-with-futures-and-options-on-the-vxewz-index.
iii "Brazil Volatility Index Futures and Options Next New Listings", Feb. 17, 2012. Press Release.
iv "Brazil's oil boom, Filling up the future". November 5, 2011. The Economist. http://www.economist.com/node/21536570.
Copyright ©2012 Mark Shore. Contact the author for permission for republication at firstname.lastname@example.org Mark Shore has more than 20 years of experience in the futures markets and managed futures, publishes research, consults on alternative investments and conducts educational workshops. www.shorecapmgmt.com
Mark Shore is also an Adjunct Professor at DePaul University's Kellstadt Graduate School of Business in Chicago where he teaches a managed futures/global macro course and an Adjunct at the New York Institute of Finance. Mark is a contributing writer to Reuters HedgeWorld
Mark is a frequent speaker at alternative investment events including events hosted by Goldman Sachs, Merrill Lynch, Morgan Stanley, Institutional Investor, International Association of Financial Engineers (IAFE), the University of Chicago, DePaul University, Tulane University, the Illinois Economics Association, the Illinois Institute of Technology, and HedgeWorld.
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Always review a complete CTA disclosure document before investing in any Managed Futures program. Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.