VIX Loses Some of Its Volatility
Shortly after the January VIX futures expired, VIX® itself registered a spike peak – sharply trading up to 37.57 on January 22nd and then falling rapidly to close at 31 that day. Moreover, the decline continued on into the next day. This spike peak is generally regarded as a bullish, intermediate-term signal for the broad stock market (i.e., for the S&P 500® Index("SPX")). The broad market did rally after that, although the rally proved to be relatively short-lived. More about that in a minute.
Since then VIX has remained in a range, trading between 24 and 29. This is relatively calm action for VIX, and as a result, the actual volatility of VIX has been declining for some time. Not only has the 50-day historical volatility of VIX itself dropped from 140% in January to about 100% today, but the implied volatility of VIX options has decreased substantially as well: in late January, VIX options had implied volatilities in the high 80’s; now the near-term options have implied volatility in the high 60’s. Normally, a declining and less volatile VIX is bullish for the broad stock market, although that hasn’t been the case of late.
As these movements occurred in VIX, the VIX futures were changing their posture somewhat as well. As was documented in the last newsletter, VIX futures, because they were trading at a substantial premium to VIX, gave a timely and accurate warning in late December of the trouble that the stock market was about to face in January. Then, adding to their stellar record, the near-term futures dropped to a substantial discount, and that was bullish. That discount persisted for several days – from January 17th through January 30th – and the SPX rose from its lows near 1300 to nearly 1395 over that time period.
Since then, as the volatility of VIX has dampened, so have any extreme readings noted by discounts or premiums, in the VIX futures. On only a few occasions so far this month has there been a discount (Feb 5th) or premium (Feb 1st and 3 days recently) larger than 85 cents in the near-term VIX futures contract, as compared to VIX itself.
Figure 1 shows the VIX index (green line) and the VIX futures contracts (colored lines). Looking at the right-hand side of the chart, where the current data is, one can see the green line well above the colored lines in mid-to-late January. That was the period of futures discounts that we referred to above, reflecting a bullish market bias.
Now all of the lines are tightly bunched together between 24 and 26, as the volatility of VIX has declined. When the futures are bunched together like this, we say that the futures pricing curve is flat. Another way to interpret the pattern is to say that this relative flatness of the volatility curve at these fairly high levels (i.e., near 25 or so) indicates that traders expect volatility to remain high through this year.
Table 1 below shows the current state of the VIX futures pricing curve. Note that the futures all the way out to November are within 1.00 point of each other, and all are quite close to VIX in value as well.
Source: MAC
Figure 1 Source: McMillan Analysis Corp.
CBOE® S&P 500 Three-Month Variance Futures
Simply stated, variance is volatility squared. [As VIX has moved higher over the past several months, CBOE S&P 500 Three-Month Variance futures have become interesting, too.] One apparent issue with trading CBOE S&P 500 Three-Month Variance futures (which are worth $50 for every point of movement), is that the variance futures market seems overly wide. In fact, however, they are not, because the width of the markets is a function of volatility.
To see why, consider this example. Back when VIX was near 10%, a volatility market might have been 10% bid, offered at 10.5%. To arrive at a variance market, square these numbers. So, the near-term CBOE S&P 500 Three-Month Variance futures contract might have been bid at 100, offered at 110 – not a bad market, being only 10 points wide.
Today, however, VIX is much higher. Suppose that the volatility market is 24% bid, offered at 25%. It is a little wider than when VIX was 10% because of the higher level of VIX. Squaring these, we arrive at 576 bid, offered at 625. Thus the variance market would be nearly 50 points wide! Some traders might think that’s inexcusably wide, considering that the markets were only 10 points wide a year ago. But, in reality, we can see that both are fair representatives of the square of the volatility market in VIX itself.
The overall increase in volatility has pushed CBOE S&P 500 Three-Month Variance futures to record highs (at least, records for the nearly four-year history of trading at CFE). Up until last summer, CBOE S&P 500 Three-Month Variance futures typically traded in the 100-200 range, often expiring at or below 100. Now, the near-term CBOE S&P 500 Three-Month Variance futures are trading above 550, and were nearly 850 last November. The near-term CBOE S&P 500 Three-Month Variance futures settle at a price equal to the actual variance of the SPX over the last 90 days of its life. As noted above, this settlement was often at or below 100, when actual historic volatility was 10% or lower. But, in September 2007, the settlement was 368 (~19.2% volatility), and in December it rose to 396 (~19.9% volatility).
While those settlements were at all-time highs for the duration of time that the CBOE S&P 500 Three-Month Variance futures contract has traded on CFE, those settlements pale in comparison to where the March CBOE S&P 500 Three-Month Variance futures contract is likely to settle. So far, the actual variance is 471.95 (~21.7% volatility), roughly halfway through the 90-day computation period. But the March CBOE S&P 500 Three-Month Variance futures are trading even higher than that (512 bid, 542 offered), so they are implying that traders expect actual volatility to increase even more during the rest of the computation period.
Just to compare, had a trader bought a Feb 2007 VIX futures contract a year ago, he would have paid about 15. It settled at 25.51 this week. That’s a gain of $10,510 per contract. In contrast, had he bought a March CBOE S&P 500 Three-Month Variance futures contract a year ago, he would have paid 218. It is now selling for 520. That’s roughly a 300-point gain, or $15,000.
That’s not to say that the CBOE S&P 500 Three-Month Variance future contracts are necessarily always going to be a better speculation than VIX contracts, but over the last year they have been.
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S&P 500 3-month Variance Futures
Variance is a measure of how spread out a distribution is. It is computed as the average squared deviation of each number from its mean. Squaring the distance from the mean has the effect of giving greater weight to values that are further from the mean. Although the variance is intended to be an overall measure of spread, it can be greatly affected by activity at the tails of a distribution. CBOE S&P 500 3-month Variance Futures are based on the realized, or historical, variance of the S&P 500 Index. CBOE S&P 500 3-month Variance Futures are quoted in terms of variance points, which are defined as realized variance multiplied by 10,000. One variance point is worth $50. For example, a variance calculation of 0.06335 would have a corresponding price quotation in variance points of 633.50, and a contract size of $31,675.00 (633.50 x $50).
Implied and Realized Components of the S&P 500 3-month Variance Futures
Because S&P 500 3-month Variance Futures are based on the realized variance of the S&P 500 Index, the price of the front-month contract can be stated as two distinct components: the realized variance and the implied forward variance. CFE will disseminate both of these values at the end of each trading day under the following tickers:
Realized Variance - RUG: An indication of the realized variance of the S&P 500 Index corresponding to the front-month Variance futures contract.
Implied Forward Variance - IUG: An indication of the future variance of the S&P 500 Index that is implied by the daily settlement price of the front-month Variance futures contract.
Variance futures contracts are forward starting three-month variance swaps. Once a futures contract reaches front-month status, it enters the three-month window during which realized variance is calculated. To calculate the variance, sum the daily returns of the S&P 500 from the swap-start date through futures expiration, then annualize the number. Because the daily returns are additive, on any day, it is possible to know both the realized variance since the first day of the swap period (RUG) and the implied variance of the S&P 500 derived from the price of the variance futures contract (IUG). For example, on March 4, 2005, the front-month Variance futures contract (VT/H5) had 10 business days remaining until settlement. Because the entire three-month swap period encompassed 62 business days, 83% of the contract's settlement value has been realized (RUG). The RUG reported by CFE that evening was 94! .97 and the VT/H5 daily settlement price was 99.50. Using the following formula, we can calculate the implied forward variance (IUG) for the remaining ten days.
Where VT is the daily settlement price for the front-month Variance futures contract. RUG is realized variance so far in the life of the contract. T is the total number of business days in the Variance futures. t is the number of business days left until options expiration.
Taking the square root of the IUG, one finds the futures price is implying an annualized S&P 500 return standard deviation or volatility of 11.09% over the next ten days. ). For more information about the S&P 500 Three-Month Variance calculation, please visit the education page for the CFE.
