CBOE Futures Exchange

August 31, 2012, Volume 6, Issue 08


A CFE Newsletter focused on Volatility Futures

Volatility Newsletter

VIX Futures Last Trade Dates

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Contract Last Trade Date
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
April 2013 04/16/2013
May 2013 05/21/2013


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

Come join CFE at the 18th Annual Institutional Investment Conference September 9-11th in San Francisco, CA where we’re Silver Sponsors!
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CFE will also be sponsoring the NIBA 2012 Chicago Conference September 12th!
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Also, you can find us at the CTA Expo in Chicago September 13th!
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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.

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Volatility trades at 5-year lows

The CBOE Volatility Index® (VIX® ) futures contract recently traded at a low of 13.30 while the VIX Index closed at 13.44, both on August 17th. These are the lowest intraday and closing prices for VIX since June of 2007. However, there is a potentially big difference between now and then; in 2007, VIX was beginning to trend higher after having spent a great deal of time below 12 the previous year. By July, the first hint of the subprime debt problems were surfacing and VIX was beginning to explode. Eventually, the rising VIX was a harbinger of the large bear market that followed. Currently VIX is trending lower and there does not seem to be the same sort of volatility risk now that there was then; at least not in the immediate future.

Some might argue that VIX is now "too low," although when one compares it to the 20-day historical volatility of the S&P 500® (SPXSM) Index it is within normal bounds. The 20-day historical S&P 500 volatility has been hovering in the mid-teens and now has recently dropped to 10. VIX being at 15 to 17 is, therefore, not unreasonable given where realized volatility is being measured.

Others say that VIX below 15 is a sign of a market top. With VIX trending lower, that particular level may not be as dangerous as it could have been. The trend of VIX is more important than its absolute level, and a downward-trending VIX tends to be a bullish sign for the stock market.

The VIX settlement value fell to 15.13 in August, arriving shortly after VIX was hitting 5-year lows. This was actually not the lowest settlement value of the year, which occurred in March, shortly before a stock market correction occurred.

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 (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.

Premium and Term Structure

There continues to be a huge appetite for volatility derivatives (see "Protection Trade" below). This continues to make the term structure of the VIX futures very steep, leaving the premium on each futures contract quite large.

Table 1 shows the state of the VIX futures term structure on Aug 24th and some of the largest premiums we have ever seen, especially in the long-term futures. April 2013 VIX futures are trading at nearly double the level of VIX itself! The premium on the near-term, front-month, September futures contract is under a bit of a constraint because it expires in three weeks and thus can't get "too far" from the value of VIX.

The "Protection Trade"

The type of VIX futures construct that we observe in Table 1 has been building for some time, roughly since last Thanksgiving. At first, it seemed there was a demand for VIX futures, much of it coming secondarily through purchases of the Exchange-Traded Note (ETN), iPath S&P 500 VIX Short-Term Futures ETN (VXX) (when a customer buys VXX and new shares of VXX have to be created, the fund manager of VXX buys VIX futures).

Recently, this activity has increased (which is a big part of the term structure steepening and the futures premium increasing). It has become part of an institutional trade that I call the "protection trade." The institutional trader buys stocks (perhaps the entire S&P 500, or just portions of it, but large-cap broad-based stocks of some sort) and at the same time hedges that purchase by buying volatility protection, most likely in the form of buying VXX. Hence this trade involves both buying stocks and buying protection. Is the trader bullish or bearish? Mostly, I would say he is bullish, but not wildly so, since he realizes that something bad could happen with VIX being so low, and therefore wants some protection.

On the surface, this is an excellent approach to the market: buy stocks and buy volatility when it is cheap. I far prefer buying volatility as protection as opposed to buying out-of-the -money put options. That's because one can use a smaller volatility hedge (as percent of Net Asset Value) and still get plenty of protection. Because if disaster strikes VIX will explode to the upside far faster than stocks could fall.

However, at the current time, VIX itself may be low-priced, but volatility futures are likely not. The average institutional trader buying VXX may not be completely aware of this, because he is not directly buying the futures, but buying VXX, which is trading at or near its Net Asset Value.


Futures Calendar Spreads

To counter against the steep term structure, one can establish calendar spreads: selling longer-term futures and buying shorter-term ones (generally in months one through three).

Hedged Futures Sales

Meanwhile, a trade that seeks to capitalize on the expensiveness of the VIX futures would be one in which one sells VIX futures and hedges it with a sale of SPX . Since they move in opposite directions (generally, VIX rises when the stock market falls, and vice versa).

With VIX futures in the rather extreme current state (see Table 1), these two hedged strategies are being employed by professional trading desks. They would be unwound if the term structure flattened and/or the near-term VIX futures lose their large premium. If the "protection trade" persists, those exit conditions might not occur until expiration of VIX futures, which is why it is important to use the relatively near-term contracts in these trades.

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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.

Much like the coaching staff of a major sports franchise reviews game-day film, looking for any information that might provide an advantage in the next contest, we like to look back at volatility futures and security futures each month following their expiration to seek insight into the growing world of volatility trading. We focus on both the absolute and relative levels representing the implied volatility expectations, for a diverse selection of assets. We look at developing trends in both volumes and open interest.

Sources: CFE, Differential Research, LLC

With the benchmark CBOE Volatility Index® (VIX®) Index setting a 5-year low of 13.79 on the Friday before expiration, August 12th, most volatility futures and security futures finished at or near life of contract lows.

Sources: CFE, Differential Research, LLC

With volatility generally falling for most of its life, the August VIX Index futures contract high settlement of $33.90 on November 25, 2011 was achieved shortly after its introduction on November 21, 2011.

Sources: CFE, Differential Research, LLC

With volatility in general rising from April through June, the Volatility Index security futures (i.e., VXEM, VXEW, GV and OV) introduced in April and the Nasdaq-100® Volatility Index (VXN) future, introduced slightly later, achieved contract highs on dates ranging from May 18th for the August VXEW security future and June 11th for the August OV security future. And while, the OV August security future achieved the highest final settlement for the group of $34.95, the VXEW August security future achieved the highest daily settlement value of $41.25.

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.

As volatility futures and 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.

Sources: CFE, Differential Research, LLC

While volatility for the August GV security future managed to settle at a discount to the August VIX future on occasion, all other futures and security futures maintained premiums to the VIX future for the period.

Sources: CFE, Differential Research, LLC

Premiums remained relatively constant with the exception of the OV security future, which saw its premium rise.

Sources: CFE, Differential Research, LLC

Once again open interest for the August VIX future steadily grew until peaking on the date of July expiration as the August future ascended to front-month status.

Sources: CFE, Differential Research, LLC

Volumes for volatility index products continues to grow, with CFE® setting five consecutive records for open interest in all VIX futures and security futures leading up to August expiration.

Sources: CFE, Differential Research, LLC

While volumes in volatility index security futures in general continue to gain traction, initial interest seems to be focused in the CBOE Emerging Markets ETF Volatility Index security future.

Sources: CFE, Differential Research, LLC

GVZ, the first of the ETF-based volatility index security futures to have been introduced, has gained interest. It would appear that a small position was steadily built over the last two months of the contract's life.

Sources: CFE, Differential Research, LLC

Viewed on a single contract basis, the August OV security future seemed to have both a high price relative to other futures but also has maintained that level consistently.

Sources: CFE, Differential Research, LLC

The August VXEW security future also premium priced however it seemed to fail to hold the premium as volatility markets fell in general.

Sources: CFE, Differential Research, LLC

The most recent volatility future launched, the August VXN future, while highly correlated with the broader market VIX future, promises to appeal to a wider group of traders with its implicit exposure to the underlying Nasdaq-100's largest index component: Apple, Inc.

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

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.


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.