Market Summary and Analysis is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation. Click Here for more information about Mr. McMillan.
The last month has been a very volatile one. VIX® has increased dramatically, and the stock market has fallen sharply. This has produced some very interesting patterns in the volatility derivatives – some of which have not been seen before, in the relatively short trading history of these listed instruments.
First of all, the November VIX futures settled at 26.70, the highest settlement price in the history of VIX futures trading. This exceeds the previous high of 25.05 in August, 2007.
Second, it is worth noting that nearly all of the VIX futures contracts have performed as a good hedge to stock market declines over this period, as the futures pricing curve has remained quite flat. That is, nearly all of the VIX futures – even those extended quite far out in time – are trading at very nearly the same price. The S&P 500® Index (SPX) has fallen from about 1540 to 1420 in the last month, a decline of roughly 8%. VIX, on the other hand, has risen from about 18.5 to nearly 27 over that same period, a rise of 45%. Most of the VIX futures have had rises similar to VIX (see Table 1), showing their worth as a hedge to owners of stock portfolios (at least portfolios which are similar in behavior to the S&P 500 Index).
Market Summary and Analysis is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation. Click Here for more information about Mr. McMillan.
The last month has been a very volatile one. VIX® has increased dramatically, and the stock market has fallen sharply. This has produced some very interesting patterns in the volatility derivatives – some of which have not been seen before, in the relatively short trading history of these listed instruments.
First of all, the November VIX futures settled at 26.70, the highest settlement price in the history of VIX futures trading. This exceeds the previous high of 25.05 in August, 2007.
Second, it is worth noting that nearly all of the VIX futures contracts have performed as a good hedge to stock market declines over this period, as the futures pricing curve has remained quite flat. That is, nearly all of the VIX futures – even those extended quite far out in time – are trading at very nearly the same price. The S&P 500® Index (SPX) has fallen from about 1540 to 1420 in the last month, a decline of roughly 8%. VIX, on the other hand, has risen from about 18.5 to nearly 27 over that same period, a rise of 45%. Most of the VIX futures have had rises similar to VIX (see Table 1), showing their worth as a hedge to owners of stock portfolios (at least portfolios which are similar in behavior to the S&P 500 Index).
Source: MAC
Note that the only reason that the VIX futures did not completely keep pace with VIX itself was that they were all trading with fairly substantial premiums to VIX back on October 18 th, whereas today they are either in line with VIX or at slight discounts.
Third, the flat shape of the VIX futures pricing curve is a predictor of volatility to a certain extent. And the prediction is that volatility is going to stay at these elevated levels for quite some time. Even the relatively long-term August ’08 futures contracts are trading above 25. This is a far cry from most of the past history of VIX futures trading (see Figure 1), when the longer-term futures routinely traded at prices of 17 or lower.
The entire history of VIX futures trading is shown in Figure1. The green line is VIX itself, while the various colored lines are the futures contracts. Recently VIX spiked up and registered a new closing high at 31.06, slightly above the August 16 closing high of 30.83 (intraday VIX was higher on August 17 th, but the data in Figure 1 is closing and settlement prices only). On the far right-hand side of the chart, all the colored lines are tightly bunched, reflecting the flat futures pricing structure that was mentioned earlier. This is distinctly different from most of the data in Figure 1, where the colored lines were evenly spread out and were trading at distinctly different prices – a condition which generally exited from the inception of futures trading through about April, 2007 (with the exception of the June correction in 2006). So, the point is that things have changed, and the futu! res are probably going to remain at these higher levels for some time to come.
Strategy – The Variance Futures Calendar Spread
Variance measures the actual volatility of an instrument. Variance is actually volatility squared, so a variance reading of 100, say, would correspond to an actually volatility reading of 10%.
In the case of CBOE S&P 500 3-Month Variance Futures (base symbol: VT), they measure the actual volatility of the S&P 500 Index. At settlement, the 3-month Variance futures settle at a price equal to the 90-day historical volatility of the S&P 500 Index. As the 90-day computation is taking place, the futures contract that will settle at the end of that period is said to be in the computation period. The other futures, however, can trade at any price, for they are not really tied to any specific thing until they reach the final 90 days of their life.
Figure 2 shows the trading history of these VT futures. For a long time, the best strategy was merely to short the contract entering the computation period, for it was routinely overpriced in that it was allowing for a larger volatility than actually took place. These expiring futures can be seen as the colored lines that drift down towards the bottom of the chart. This changed with the September ’07 contract, which settled much higher at the end of the computation period than when it began the period, reflecting the increased volatility of the stock market in August.
Now, there is perhaps an opportunity for a spread in the VT futures. The March ’08 contract has risen to extremely inflated levels as traders have sought to use it as a hedge against falling stock prices. While that is a valid use of the contract, it seems to have gotten overdone. On the very far right-hand side of Figure 2, note how much of a spread there is between the blue line (March ’08 futures) and the yellow line (June ’08 futures). This is much greater than at any other time in the VT futures price history – with one possible exception: August-September, 2007. At that time, the contract just past the computation period (December ’07) got very inflated, before eventually coming back down to earth when the broad stock market began to stabilize and volatility decreased. A similar setup may exist now.
At Wednesday’s settlement (11/21/07), these were the prices:
March ’08 VT futures: 846
June ’08 VT futures: 733
This is very inflated, but if one sold the spread for 113 points, March over June, he could conceivably buy it back near zero, or it might even invert if the broad stock market rallied far enough. Moreover, once the December VT futures expire on December 21 st, the March ’08 contract that is currently so inflated will enter the computation period, and that should help bring it down to more reasonable levels as well.
The risk in this strategy is that spread could continue to widen if the stock market continues to fall in a volatile manner. This is because the March contracts will still be in demand as a hedge against rising volatility. Furthermore, these futures are somewhat illiquid, so there are very wide markets.
So, weigh the risk factors as well as the potential reward. But, if the stock market is about to stabilize or rally, this Variance Futures calendar spread will shrink, and thus this may be a good way to play the situation. The speculative margin required for a Variance Futures calendar, where neither futures contract is in the computation period, is $2,625.
Trading the Direction of Implied Volatility
The most straightforward application of VIX futures and options is to trade implied volatility. While implied volatility can also be traded with straddles or by unwinding delta-hedged option positions, VIX contracts offer a cleaner and less costly exposure which does not need to be adjusted when the market moves. Another attractive feature is that VIX is relatively simple to track and that it can be forecast from several readily observable variables: the current deviation of VIX from its mean, past realized volatility, the performance of the S&P 500, and even the month of the year.
Implied Volatility Spreads
An alternative to an outright position in implied volatility is the exposure to changes in implied volatility obtained by spreading between successive VIX futures contracts. For example, a spread short March VIX futures and long April VIX futures will earn a positive return if the expected difference between May and April volatilities widens.
Hedging Market Risk and Portfolio Diversification
The tendency of VIX to increase when the S&P 500 decreases implies that money managers can buy VIX futures to hedge equity portfolios. VIX futures are also useful for portfolio completion and diversification because the mean return and volatility of VIX are significantly higher than those of core assets (equities, bonds, commodities and real estate) and because it is weakly correlated to non-equity assets. Adding VIX to a portfolio expands investors' risk-return opportunity set even when the portfolio appears already broadly diversified.
Hedging Implied Volatility Risk
Because VIX futures settle to the implied volatility of the S&P 500, they are natural to hedge the "vega" risk of S&P 500 options. VIX futures are also effective to cross-hedge the vega risk of stock options and stock indexes correlated to the S&P 500, whether these are exchange-traded or embedded in other assets.
Hedging or Spreading against Realized Volatility Risk
The high correlation between implied and realized volatility also makes VIX futures effective for hedging and spreading against investments or strategies exposed to realized volatility risk, e.g. volatility swaps, stock index arbitrage strategies, and indexed portfolios whose rebalancing costs and tracking error costs mount when volatility increases.
Consultant's Study on the CBOE DJIA Volatility Index (VXD)
In 2007, the Fund Evaluation Group (FEG) issued a new study entitled, "Evaluation of BuyWrite and Volatility Indexes - Using the CBOE DJIA BuyWrite Index (BXD) and the CBOE DJIA Volatility Index (VXD) for Asset Allocation and Diversification Purposes." The paper studied the 109-month period from October 1997 to November 2006. The FEG study presented several findings on the 9-year performance of the VXD, including:
* Volatility Index Can Reduce Portfolio Volatility. Including a small (10%) allocation to the VXD could have reduced the volatility of an all-stock portfolio by about 26%, without materially affecting returns.
* Low Correlation and Diversification. The VXD and the DJIA were inversely correlated (-0.62) over the course of this study. The study showed that the VXD increased more during market declines (the VXD reacted more to stock market declines than to stock market advances), indicating that the VXD has potential as a diversification tool.
Impact on Risk-Adjusted Returns. The inclusion of a small (5%) allocation to the VXD boosted risk-adjusted returns for a stock-oriented portfolio, and lowered the risk-adjusted returns for a fixed-income-oriented portfolio.
About CBOE Futures Exchange CBOE Futures Exchange (CFE®) is an all-electronic open access exchange, which utilizes the CBOE’s® state-of-the-art trading system, CBOEdirect®. CFE is the leader in providing innovative volatility risk management futures products, including VIX® and variance futures, which enable market participants to manage volatility risk, as well as trade volatility directly. Access to CFE is available through numerous brokers, ISVs or directly via the CBOEdirect API or CBOE’s HyTS® terminals. CFE trades are cleared by the AAA-rated Options Clearing Corporation (OCC). To contact the CFE, please click here. About Larry McMillan and McMillan Analysis Corporation 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 Uni! ted States, Canada, and Europe. He is quoted in publications such as < u>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.
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