iVol Trading

May 2010

The VIX, as the CBOE Volatility Index is commonly known, has gained in prominence over the last year and a half since the financial crisis. A CNBC day would not be complete without some mention of the “fear index” and its various ups and downs. Numerous blogs are dedicated to the topic, and it has its own daily video from the options pit – the Volatility Sonar.

And while I am a big fan of making the volatility index a household name, it is important to understand what the VIX really is, as misleading information about the VIX seems to dominate many of these discussions. Even the term “fear index” is a misnomer at best and downright misleading at times. Yet the relationship between the VIX and the broad markets, especially during times like the crisis of 2008 keeps this idea alive.

The VIX measures the implied volatility of the SPX S&P 500 options. It is an index that is calculated throughout the day and is the market’s expectation of the volatility over the next 30 days. It is not the volatility that is actually in the market, but the volatility that is implied by the prices of the options. This means that there is factor of supply and demand as well. When demand for options is high, the premiums will be higher and therefore the implied volatility of those options will be higher. Because of the dynamics of the markets, it is often useful to think of implied volatility as the price of portfolio insurance.  

The VIX isn’t new, even if the constant talk of it is. The Volatility Index was born in 1993 out of a paper by Professor Robert Whatley, currently of Vanderbilt University. At that time the index was calculated from the front 2 month at-the-money options of the OEX S&P 100 Index (now that index is known as the VXO). It was calculated back to 1986 so that the crash of 1987 could be used as a comparison for future volatility spikes. Back in 1987, the VIX (now VXO) briefly climbed over 150, so the levels of October, 2008 – which remained below 100 – were not actually unprecedented.

In 2003, the index was reconstructed using a much wider range of options of the SPX S&P 500 Index. The SPX had become the more widely traded index by a considerable amount while trading in the OEX had fallen off. Because of the improved systems on the trading floors, more strikes could be used, so all strikes with a bid are used in the calculation so that the volatility skew is part of the calculation. This can be seen in the fact that the implied volatility of the at-the-money SPX options is less than the VIX. The inclusion of the out-of-the-money put options with higher implied volatilities makes the VIX higher.

This last issue is an important one. The SPX options are mainly used to buy puts as protection for equity portfolios. Since puts increase in value when the price of the index falls, they are insurance against the inevitable drops in the broad markets. Many also sell upside call options in a collar strategy to help offset the cost of the puts. This buying pressure on the downside increases the implied volatility of the out-of-the-money puts, hence the volatility skew.

This protective put buying also helps explain the behavior of the VIX. The VIX does increase when the SPX falls – this is the root of the “fear index” moniker. The insurance analogy is apt here. When the flood is on the way, the price of flood insurance goes up proportionally. And when your basement is filling with water, that insurance is going to be really expensive. Similarly, when the market is rising, less people are interested in insurance, so the VIX is low. When the market starts to fall, the interest in insurance increases, driving up the price of the SPX puts, and therefore of the VIX. So we have the inverse relationship between the VIX and the SPX.

There is a more fundamental aspect of the VIX which also explains this behavior. We know that the VIX measures implied volatility, not the actual volatility in the market, but the two are inexorably intertwined. Because the current volatility – usually measured as the 30 day historical volatility – is the basic starting point for estimating future volatility, option sellers usually aren’t willing to sell SPX options at volatility levels below that historical volatility level.

This accounts for the reason that the VIX is often higher than the subsequent realized volatility. That was certainly the case for most of 2009. This can be partially attributed to the volatility spike of late 2008 and the supply and demand dynamics of SPX options. Many option sellers were burned in September and October 2008 – if not outright blown up and out. There are less option sellers and those that are left demand more in terms of risk premium.

Because of this link between implied and realized volatility, a rise in the actual volatility of the market will also increase the VIX. Realized volatility often increases when the market drops sharply. We saw this in September 2008, as the historical volatility actually outpaced the VIX. When the VIX was up above 80, the 10 day historical volatility was all the way up above 100.

But there are times when the market rises with increasing volatility. The VIX will increase in such cases and it isn’t necessarily increased fear that is being shown. The reverse can also be true. The VIX fell 70 percent in 2009. This drop can be accounted for as much by the fall in historical volatility as by any decrease in investor fear. When the VIX hit its recent high above 90, the SPX was above 850. But when the SPX fell to the March low below 700, the VIX had fallen more than 40 percent to a level below 50. This is because the decline into March came with less realized volatility, not necessarily less fear.

VIX spikes often coincide with SPX bottoms, leading to the saying, “when the VIX is high its time to buy”, and the corollary, “when the VIX is low, its time to go”. This should make sense at this point. When everyone is rushing to buy insurance and paying any price to get it, things are at their worst. So it was back in 2007 and 2008, when traders saw any spike above 30 in the VIX as a buying opportunity in the SPX.

But the VIX isn’t causal. A rising VIX does not cause the SPX to fall. If anything the relationship works the other way, though it is clearly a complex relationship. And the VIX isn’t predictive. Some back them claimed that any move of the VIX above 30 predicted a bottom in the SPX and subsequent higher prices for the broad market. But clearly that isn’t the case, as the VIX climbed right on through 30 – and 40, 50, 60, 70 and 80 – and the SPX kept falling.

Others claimed that the VIX was “broken” because it didn’t predict the drop in the SPX as it collapsed from above 1250 to 850 in the course of a month. The claim that the VIX is broken comes out whenever it doesn’t act as some expect, or when it doesn’t behave as a “fear index” should.

The VIX is a statistical measure. It is a one standard deviation, 30 day volatility reading that is annualized. So if the SPX is 1000 and the VIX is 32, it means that the 30 day options are implying that there is 68 percent probability (1 standard deviation) that the SPX will be higher or lower by 32 percent or between 680 to1320 over the next year. There is a 95 percent chance (2 standard deviations) that the SPX will be higher or lower by 64 percent (560 to 1640). Daily and monthly expectations can be calculated from the annualized number. The VIX of 32 would imply daily moves of approximately 2 percent 68 percent of the time (32 divided by the square root of 252, the accepted number of trading days in a year).

A VIX of 32 implies monthly moves of a little more than 9 percent. Clearly the 32 percent drop from 1250 to 850 is bigger than that. But looking at the standard deviation measurement, a 27 percent move would be 3 standard deviations – covering 99 percent probability. The 32 percent move just happed to be the 1 percent that fell in that 4^th standard deviation and had a 1 percent change of happening given the level of the VIX. So the VIX isn’t “broken” when these things happen, just misunderstood.

The Tradable VIX

Option traders have been trading volatility for a long time. But the idea of a “tradable” VIX was very appealing from its introduction. Studies were done that had shown that a investing in 90 percent SPX and 10 percent VIX was, in most respects, the perfect portfolio.

The 2003 change in the VIX calculation allowed for VIX futures to be launched the following year and for VIX options to be rolled out in February of 2006.  More recently, a couple of ETNs have been added to the suite of tradable products based off of the VIX. So the tradable VIX came into being, but the perfect portfolio remains elusive. Confusion abounds when it comes to these tradable products and that confusion has had a hefty price tag.

VIX futures are listed out for the next nine months and trade only on the CFE CBOE Futures Exchange. This creates some issues, as not many futures brokers support the CFE, so they can be hard to get access to. Starting in February 2006, the VIX options provided the first widely accessible access to VIX trading. Volume in the VIX options has grown dramatically, and it is now one of the most widely traded options series, with a daily average volume of over 300,000 contracts at the end of 2009.

The VXX Short Term VIX Futures ETN and VXZ Medium Term VIX Futures ETN were rolled out by Barclay’s in February of 2009. The VXX was the most popular ETN or ETF launch of 2009 with almost $1 billion shares traded. Unfortunately it was also one of the worst performers as well. Traders and investors have poured money into the VIX options and VXX with the idea of owning a truly non-correlated instrument that increases in value when the SPX drops. Many of those traders and investors have been disappointed due to their misunderstanding of the very nature of the instruments.

The VIX options and the VXX are not based on the VIX. They are based off of the VIX futures. The VIX futures can be substantially different from the spot VIX, and from each other. VIX futures are essentially predictions of where the VIX will be on a certain day – the day that the VIX futures settle, at which point they converge with the spot VIX. The VIX is mean-reverting and despite its own volatility tends to come back to the average. So when the VIX is low, the expectation is for it to rise, and when the VIX is high, traders expect it to fall.

It can be useful to think in terms of weather predication. If the average temperature for October is 50 degrees, and it spikes up to 75 degrees, we might expect October to have more hotter-than-average days. But how much do we expect it to affect the average temperature in December or February?

Similarly, when the VIX shot up above 90, the highest the then front month VIX future got was 65. And the longer dated futures didn’t rise much at all, barely breaking above 30. The VIX futures were showing that traders expected the VIX to come back down by expiration and return to more normal levels within a few months. That is, of course, basically what happened, though the return to “normal” took longer than expected. Traders that owned front month VIX calls got exceptional returns, though not as much as they might have expected from the movement of the spot VIX. Traders and investors who owned longer dated VIX calls barely had any gains out of the positions, and certainly not the disaster hedge they were looking for.

The VXX opened at 100 back in February, climbed to 120 later that month and closed out 2009 all the way down at 34.07. The VIX, on the other hand, was around 45 when the VXX arrived, and closed the 2009 at 21.68. It seems, that as many pundits suggested, the VXX was a failed ETN – despite its popularity – in that it didn’t track the VIX well at all. But as its name suggests, the VXX Short Term VIX Futures ETN tracks the VIX futures, not the spot VIX.

We can look at the current term structure to get a better understanding of this. At the end of 2009 with the VIX at 21.68, the January VIX futures closed at 22.95, and February 25.75. The premiums in these futures over the spot VIX speak to the mean-reverting nature of volatility and traders’ expectations that the higher volatility levels of 2009 were expected to come again.

Since the VXX is made up of the front 2 month futures, it is already pricing in a rise in volatility. It also rolls out from one month to the next daily, and as the premium in the February futures is even greater than that in the January futures, that is clearly not a profitable proposition. If that rise in volatility does not come, the VIX futures will collapse the spot level of the VIX. That is what we have seen since March, and is the explanation for the underperformance of the VXX compared to the VIX.

This disparity between the VIX and the VIX futures also explains some of the peculiar action in the VIX options. Traders may buy a VIX 30 strike call and find that they don’t get the returns they expect when the VIX spikes up to 30. This is likely due to the fact that the VIX futures only rose to 26 or 27, and the options are priced off those futures.

All of this means that the VIX options and futures, including the VXX, are trading vehicles, not investments. The VIX options can be the best disaster hedge, but you have to stick with the front month VIX to get the most bang for the buck. The VXX can be a good portfolio hedge as well, as long the dynamics are understood, and the expectations as well as the holding period are appropriate.

The VIX may not be the “fear index” that some sell it as. And trading the VIX may be difficult task. But having an understanding of the VIX is exceptionally helpful to option and equity traders and investors alike. Traders who understand the VIX in relation to its past, what it is saying about the future, and its relation to realized volatility and VIX futures are armed with knowledge that put them in a great position to understand the markets and profit from them. Those that are willing to go a step further to understand the VIX options and futures open up a whole arena of opportunity that few play in and fewer truly understand.