Is Volatility in Your Future? CBOE Futures Exchange's new VIX Futures

By Patrick Fay   ISSUE 304 | MAY 2004

What’s your take on volatility in the marketplace? Have you been tracking the CBOE’s Volatility Index® (VIX®)? Now there’s a futures product you can trade based on the VIX. The VIX futures contract, which began trading on Friday, March 26, 2004, is the first product to be offered by the new CBOE Futures Exchange, LLC (CFE), a fully electronic exchange owned by the Chicago Board Options Exchange. CFE was granted contract market status by the CFTC in August 2003. CFE uses CBOEdirect as its trading platform.

While VIX futures are new, CBOE's Volatility Index, the index upon which the contract is based, dates back to 1993. VIX, widely held to be the benchmark of stock market volatility, measures market expectations of near-term volatility conveyed by stock index option prices.

For many investors, volatility connotes financial turmoil, so VIX is often referred to as the "investor fear gauge." VIX is based on real-time options prices, which reflect investors' consensus view of future expected stock market volatility. Historically, in periods of financial stress, which are often accompanied by steep market declines, option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, in turn causing VIX to decline.

Changes to the Original Volatility Index

VIX was originally constructed using the implied volatilities of eight different OEX (S&P 100 Index) options series so that, at any given time, the index would represent the implied volatility of a hypothetical at-the-money OEX option with exactly 30 days to expiration.

With the introduction of VIX futures, the index has been reconstructed, and while it still measures the market’s expectation of 30-day forward volatility, it measures it differently. The New VIX uses options on the S&P 500 Index, which is the primary U.S. stock market benchmark. It is calculated using a wide range of strike prices in order to incorporate information from the volatility skew. And, it uses a newly developed formula to derive expected volatility directly from the prices of a weighted strip of options, rather than from an option-pricing model.

Why the changes? Because the CBOE wanted to provide a more precise and robust measure of expected market volatility and create a viable underlying index for tradable volatility products.

To this end, the New VIX calculation is intended to reflect the way financial theorists, risk managers and volatility traders think about – and trade – volatility. It conforms more closely to industry practice than the original VIX methodology. It is simpler because it uses a formula that derives the market expectation of volatility directly from index option prices rather than from an algorithm that involves backing implied volatility out of an option-pricing model. And, it is more robust because it pools information from option prices over a wider range of strike prices, thereby capturing the whole volatility skew, rather than just the volatility implied by at-the-money options.

The changes also increase the practical appeal of VIX. As noted previously, the New VIX is calculated using options on the S&P 500 index, the widely recognized benchmark for U.S. equities, and the reference point for the performance of many stock funds. The S&P 500 also is the domestic index most often used in over-the-counter volatility trading.

In addition, this calculation supplies a script for replicating the New VIX with a static portfolio of S&P 500 options. This critical fact lays the foundation for tradable products based on the New VIX.

What Remains the Same

Despite the changes, the fundamental nature of VIX remains the same. The New VIX still uses index option prices to measure the market’s expectation of near-term stock market volatility. It still uses a weighted average of options with a constant maturity of 30 days to expiration. And, it is still calculated continuously in real-time throughout the trading day.

How do these changes impact VIX levels and the way the VIX responds to markets moves? The New VIX value is different than the original VIX, but the difference is relatively small. The new VIX behaves very much like the original in that it tends to increase during stock market declines, and decrease when the market advances. However, this historic tendency doesn’t imply futures results will be similar.

The original VIX hasn’t gone away, but its ticker symbol is now “VXO.” The same formula and methodology used to calculate the New VIX has been applied to the CBOE’s NASDAQ-100 Volatility Index (VXN), however, the New VXN calculation is still predicated on the NASDAQ-100 index option prices.

For contract specifications, quotes, historical data, performance charts and more, please visit the CBOE’s Web site, at www.cboe.com.

Patrick Fay is Managing Director of the CBOE Futures Exchange.

Laura Oatney is editor of LindForum. She can be reached at editor@Lind-Waldock.com.

Futures trading involves risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources, which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading Advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

© 2004 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved. Futures Trading Involves Risk of Loss.