CBOE Futures Exchange

June 28, 2012, Volume 6, Issue 06


A CFE Newsletter focused on Volatility Futures

Volatility Newsletter

VIX Futures Last Trade Dates

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Contract Last Trade Date
July 2012 07/17/2012
August 2012 08/21/2012
September 2012 09/18/2012
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


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New Single-Day Volume Record Set On Monday at CBOE Futures Exchange on Monday June 18, 2012. Read more...

VIX Futures Experience Most-Active Trading Week Ever.

CBOE Risk Management Conference Europe September 5-7, 2012.

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

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.

CFE Volatility Newsletter

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June 22, 2012

Volatility backs off
Shortly after the last expiration, VIX rose while the market fell eventually reaching a high near 28 in early June, and just as the stock market bottomed, as measured by the Standard and Poors 500 Index® (SPX). Since then, VIX has been trending lower, while SPX has trended higher. This is rather normal action. Perhaps the most significant fact is that VIX fell back below 21, a level which has been important for most of this year. When VIX is below 21, stocks have generally been bullish. When VIX has been above 21, a much more bearish stock market has emerged.

By falling below 21, VIX has returned to the 17-to-21 range that has contained its movements for much of 2012. VIX spent a short while below that range in March but above in May and June.

The VIX settlement value fell to 17.78 in June, just as the stock market was making highs for that month (and, consequently, VIX was making monthly lows). This is the second lowest settlement price in the last 15 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 Index (SPX) is also overlaid on the graph. While there is not a perfect (inverse) correlation between SPX 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

Premium and Term Structure
Table 1 shows the state of the VIX futures term structure on June 22nd. Each of the futures are trading with a very large premium to VIX itself. Furthermore, the term structure (the relationship of the futures prices to each other) slopes steeply upward. This combination of large VIX futures premium and a steep term structure is generally reflective of a bullish market. It should be pointed out that the premium and term structure have been exacerbated by the heavy demand for VIX futures via the volatility ETFs that are very popular.

These premium levels and steepness are some of the most extreme we have ever seen. There was heavy buying of VIX futures just before the close of trading on June 22nd, which contributed to an already-steep term structure.

Even when the market declined in late May and early June, the term structure retained an upward slope, although much less than is being exhibited now. That was the case even though SPX corrected by about 10%. Usually, in a 10% market correction, the term structure would flatten and perhaps even invert. But the fact that it has not is a modestly bullish outlook for the market.

As has been the case over the last few months, the front month VIX futures premium is starting out the new month at premium levels well above 3.00. Historically, that is a very large premium for the front month, but with the voracious demand for protection that exists in today’s marketplace, this is the inevitable result.


Futures Premium Strategy There are two basic strategies that apply when the construct of the VIX futures is where it is now. First, when futures premiums are high, the general theory is to sell expensive VIX futures premium. But that short position alone would have too much risk. So a hedge is needed. That hedge would be to sell SPX futures or the equivalent. That is, a short position in volatility is hedged by a short position in the stock market.

An extension of this strategy would be to buy puts on both markets. Buy puts on both VIX and SPX. The formula we printed last month for this strategy is still apropos, so it is included again this month as well:

Ratio of VIX to SPX = (SPX price) x (SPX 20-day historical volatility)
                                (July VIX futures price) x (July VIX futures 20-day historical volatility)

What is also very unusual is that the 20-day historical volatility of SPX is quite low (19%), considering how much movement there has been in the market in the last month. The July VIX futures have no such hindrance, as the 20-day historical vol of July VIX futures is a whopping 99%. These extremes in historical volatility made the ratio of VIX to SPX almost 1-to-1, which is far from the historic norm of 2 VIX to 1 SPX.

Futures Term Structure Strategy However, there is another strategy that can be used at this time as well. That is calendar spreads in the futures, seeing that the term structure is so steep. Since the term structure slopes steeply upward, one would want to buy the front month futures (July) and sell either August or September against them. If the term structure flattens, then such a spread would profit. The reduced exchange margin requirements only apply to spreads in the first three months, so one’s position should be in those futures.

This strategy has risk if the term structure steepens further. That could happen if the stock market (SPX) rose in price.

In summary, with the futures holding onto large premium levels and with the term structure so steep, this is an appropriate time for either of these strategies. These conditions may continue to persist for some time, but they must disappear by expiration. The ETF buyers are most likely the main impetus behind this elevated construct that we see in the VIX futures, and so as long as they persist in buying ETFs, trades like these will be available to the knowledgeable derivatives hedger.

VIX Futures in Focus

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VIX Futures in Focus is provided by Michael McCarty. Mr. McCarty is the founding member and chief strategist of Differential Research.

Inter Market Volatility Arbitrage IV

As volumes continue to grow in CBOE Volatility Index® (VIX®) futures (VX) as well as in the recently launched volatility index security futures, we continue to look at the relative relationships to better define, quantify and ultimately attempt to capitalize on inter-market volatility arbitrage opportunities.

Sources: CFE, Differential Research, LLC, Yahoo Finance

This month’s expiration of volatility index security futures followed a turbulent period rising and falling dramatically, before settling near life of contract lows.

Sources: CFE, Differential Research, LLC

Volumes for volatility products continues to grow, as CFE set all-time single-day trading records for both total exchange volume and VIX futures contracts volume on June 18th.

Sources: CFE, Differential Research, LLC, Yahoo Finance

Volume and open interest in the June 2012 VIX future peaked, as the contract ascended to the front month slot from the second serial future position. Highlighting the influence of volatility ETN’s that target a theoretical 30-day duration VIX future.

Sources: CFE, Differential Research, LLC, Yahoo Finance

While volume continues to gain traction in the volatility security index futures, initial interest seems to be focused in the CBOE Emerging Markets ETF volatility product. Although, the June CBOE Crude Oil ETF future saw volume exceed 500 contracts on two occasions.

Sources: CFE, Differential Research, LLC, Yahoo Finance

Open interest seems to suggest that the oil volatility trade represented a single position established and later closed, while open interest in the emerging markets volatility product suggests more active trading.

Sources: CFE, Differential Research, LLC, Yahoo Finance

While the different volatility futures are generally correlated, each asset class demonstrated unique characteristics rising or falling independently.

Sources: CFE, Differential Research, LLC, Yahoo Finance

While the 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.

In the last several issues we have looked at the mathematical correlation between different volatility markets investigating relative performance and relationships between various asset-classes of volatility futures. However, the most recent period provides a unique analysis opportunity as volatility rapidly rose and fell during the life of the expiring contracts.

Sources: CFE, Differential Research, LLC, Yahoo Finance

Our look this month, although the data is extremely limited, is a very simplistic look at the relative performance of the various contracts from the May VIX future low on May 2nd to the June VIX future high on June 1st and then again from the June 1st VIX future high to expiration.

Reflecting partially the bias of selecting the VIX future lows and highs, the VIX future lost most over the decline. However, during the period when volatility generally rose, the oil volatility future witnessed the greatest percentage increase. Most interestingly, following its game winning gain, the oil volatility future lost the least of all the expiring volatility contracts.

Sources: CFE, Differential Research, LLC, Yahoo Finance

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

NASDAQ-100 Volatility Futures (VN) with a multiplier of $1,000 began trading in May with the July contract the first to expire.

VIX White Paper

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The CBOE Volatility Index (VIX ) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility.

VIX White Paper (Acrobat).

CBOE Volatility Indexes

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CBOE's volatility indexes are key measures of market expectations of near-term volatility conveyed by stock index option prices. The indexes measure the market's expectation of 30-day volatility implicit in the prices of near-term index options. The indexes are quoted in percentage points, just like the standard deviation of a rate of return, e.g. 19.36. CBOE disseminates the index values continuously during trading hours. The indexes are leading barometers of investor sentiment and market volatility relating to key stock indexes.

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?


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.

Copyright 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.