New Volatility Index Futures for Oil & Gold

 

As the VIX languishes in the doldrums of teen spirit, lulling market participants to sleep before volatility comes screaming back to life, the CME & CBOE have announced a partnership that will create futures (and options on futures) for volatility indexes across a variety of asset classes.  Beginning with Oil, Gold, Corn and Soybeans, these new derivative instruments are scheduled for launch in Q3 of 2010.  Each benchmark index will be established upon the CBOE Volatility Index® (VIX®) methodology and price series will originate from CME Group options on futures contracts via the most active electronically traded front and nearby contracts.

[1]  CME press release

[2]  Crude Oil, Gold & Euro Volatility Index charts

[3]  CBOE primer on just what the heck the VIX actually is


 

CHICAGO, March 5  -- CME Group, the world's leading and most diverse derivatives marketplace, today announced it has entered into a seven-year license agreement with the Chicago Board Options Exchange (CBOE) that will allow CME Group to list futures and options on futures for volatility indexes on a variety of asset classes. These contracts will be listed with, and subject to, the rules and regulations of the particular exchange where the products will be traded (CME, CBOT or NYMEX).

 

"Our liquid and transparent commodity and financial markets are the foundation for the creation of new indexes that customers can use to gain a view on volatility across a wide array of asset classes," said Scot Warren, CME Group Managing Director of Equity Index Products and Services. "We believe that a reliable benchmark index for volatility sentiment on contracts such as WTI Crude Oil, Corn, Soybeans and Gold will help market participants make more effective investment and hedging decisions based on their exposure to market volatility."

 

Terms of the license agreement between the exchanges include the following:

  • CBOE will create, own and calculate the benchmark indexes using its established CBOE Volatility Index® (VIX®) methodology and license use of the indexes to CME Group.
  • The benchmark indexes are scheduled to begin publishing data during the third quarter of 2010.
  • Prices used in the calculations will originate from CME Group options on futures contracts. The data will use the most active electronically traded front and nearby contracts across commodity and financial products.
  • CBOE will be the initial market disseminator of prices for the volatility indexes. {1}


 

Crude Oil Volatility Index ~ Daily

 

Oil Volatility Index ~ Daily

 

 Gold Volatility Index ~ Daily

 

Gold Volatility Index ~ Daily

 

Euro Currency Volatility ~ 240-minute

 

Euro Volatility Index ~ 240-minute

 


 

For a primer on what the CBOE Volatility Index (commonly known as 'the VIX') actually is, we turn to the CBOE itself.

 

1.  What is VIX?


The CBOE Volatility Index - more commonly referred to as "VIX" - is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500® Index (SPX) option bid/ask quotes. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.

 

 

2.  How is VIX calculated?

 

Calculation is independent of any theoretical pricing model, using a formula that averages the weighted prices of at-the-money and out-of-the money puts and calls to derive expected volatility. More information and a sample calculation may be found at the VIX White Paper [attached below].

 


3.  How do VIX options allow me to trade volatility

 

The VIX formula isolates expected volatility from other factors affecting option prices, such as changes in underlying price, dividends, interest rates and time to expiration. As such, VIX options offer a way for investors to buy and sell option volatility simply and directly, without having to deal with the other risk factors that would otherwise have an impact on the value of an SPX option position.

 

 

4.  I'm used to options expiring on the third Friday of each month.  Why do VIX options expire on a Wednesday?

 

VIX was designed to be a consistent, 30-day benchmark of expected market volatility, as measured by SPX option prices. Of course, there is only one day in the life of any option that is exactly 30 days to expiration, so in order to arrive at the 30-day standard, VIX is calculated as a weighted average of options expiring on two different dates.

 

One day each month, on the Wednesday that is thirty days prior to the third Friday of the following calendar month, the SPX options expiring in exactly 30 days account for all of the weight in the VIX calculation. VIX options settle on these Wednesdays in order to facilitate the special opening procedures that establish opening prices for those SPX options used to calculate the exercise settlement value for VIX options.

 

 

5.  Will VIX options always reflect current, real-time VIX values?

 

Probably not, at least not until you get close to expiration. The underlying for VIX options is the expected, or forward, value of VIX at expiration, rather than the current, or "spot" VIX value. This forward value is estimated using the price quotations of SPX options that will be used to calculate the exercise settlement value for VIX on the expiration date, and not the options used to calculate spot VIX. For example, VIX options expiring in May 2006 will be based on SPX options expiring 30 days later - i.e.; June 2006 SPX series. In fact, June SPX options do not even enter into the spot VIX calculation until April 17, 2006.

 

Some VIX options investors look at the prices of the VIX futures to gain a better general idea of how the market is estimating the forward value of VIX.

 

VIX option prices should reflect the forward value of VIX, which is typically not as volatile as spot VIX. For instance, if spot VIX experienced a big up move, call option prices might not increase as much as one would expect. Depending on the value of forward VIX, call prices might not rise at all, or could even fall! As time passes, the options used to calculate spot VIX gradually converge with the options used to estimate forward VIX. Finally, at VIX options expiration, the SPX options used to calculate VIX are the same as the SPX options used to calculate the exercise settlement value for VIX options.

 

 

6.  How is the exercise settlement for VIX options calculated?

 

The exercise settlement value for VIX options (Ticker: VRO) is a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices of the SPX options used to calculate VIX at settlement. Most of the SPX option opening prices typically reflect actual trades. The opening price for any series in which there is no trade is deemed to be the mid-quote price, the average of that option's bid and ask prices. Only series with non-zero bid prices upon completion of the special SPX opening procedures are used in the SOQ calculation.

 

 

7.  How is the calculation of hte VIX SOQ different than the calculation of other VIX values?  What can this mean for VIX options settlement?

 

It is important to note that the VIX SOQ is the only VIX calculation that uses traded prices. Every other reported VIX value uses mid-quote prices of SPX option series. Typically, the theoretical VIX bid/ask spread (i.e., the difference between VIX calculated using bid prices and VIX calculated using ask prices) is 0.8 to 1.2 VIX points. If the VIX SOQ is calculated using predominantly bid prices, or predominantly ask prices, there may be a significant difference between the exercise settlement value for VIX options and the reported VIX values (based on mid-quote prices) on expiration day as well as at the close on the day before expiration.

 

 

8.  Why do VIX options prices appear different than other index option prices I'm used to seeing?

 

The price of any index option depends on the forward price of the index and the expected shape of the forward price distribution. In the case of stock indexes like the S&P 500, the theoretical forward price is determined in a fairly straightforward manner that considers the "cost-of-carry" (i.e., interest rates and dividend yields). Forward prices of option volatility exhibit a "term structure", meaning that the prices of options expiring on different dates may imply different, albeit related, volatility estimates. VIX option prices reflect the market's expectation of the VIX level at expiration, as measured by the VIX SOQ on that date. For example, prices for VIX options expiring in May 2006 reflect the expected volatility implied in June 2006 SPX options; VIX options expiring in August 2006 reflect the expected volatility implied in September 2006 SPX options, etc. The VIX volatility implied by June SPX options may be significantly greater or lower than VIX volatility implied by September SPX options.

 

Most readily available option pricing models assume that price changes in an underlying asset - IBM or S&P 500 Index (SPX), for example - have a lognormal distribution. The distribution of VIX prices is not lognormal. In a lognormal world, the price of IBM, for instance, could go to $0 per share, or rise to very high levels depending on market conditions and company fundamentals. A VIX value of zero, on the other hand, would imply a market expectation of virtually no daily change in the level of the S&P 500 Index! Extreme or persistently high VIX levels are just as unlikely because there would need to be a market expectation of very large daily SPX index changes over an extended period of time. Yet, since 1990 the largest 1-day move in SPX has been -6.9%, and price changes of at least ±5% have occurred only 8 times.

 

Option practitioners commonly refer to the unique behavior of VIX and other volatility measures as "mean-reverting," which is a statistical way of saying that at historically low VIX levels, there is a higher probability that the next big move will be up rather than down. Conversely, at historically high VIX levels, the next big move is more likely to be down rather than up.

 

Because of these differences between VIX and traditional stock indexes, calculating exact theoretical values for VIX options can be very complex. Assuming that VIX option prices reflect the "term structure" and "mean reversion" characteristics of VIX, VIX options could appear somewhat peculiar relative to other index and individual stock options.

 

 

9.  What is the "volatility of volatility"?

 

The expected volatility of VIX forward prices is another important factor influencing VIX option prices. But what is the "volatility of volatility"? It turns out that volatility, as measured by spot VIX values, is indeed very volatile. As shown in the following table, the volatility of the VIX Index was higher than the volatility of the S&P 500 Index (SPX), the Nasdaq-100 Index (NDX) and the Russell 2000 Index (RUT), and several stocks, including Google, Apple and IBM.

 

Name 12/31/08
Price
2008
Volatility
VIX 40.00 127.3%
VX Near-Term Futures 41.94 88.9%
SPX 903.25 41.0%
NDX 1,211.65 42.3%
RUT 499.45 46.4%
GOOG 307.65 55.2%
AAPL 85.35 58.2%
GM 3.20 115.7%
IBM 84.16 36.1%
MSFT 19.44 48.5%
C 6.71 116.8%
Name 12/31/09
Price
2009
Volatility
VIX 21.68 88.9%
VX Near-Term Futures 22.95 69.2%
SPX 1,115.10 27.3%
NDX 1,860.31 26.5%
RUT 625.39 36.2%
GOOG 619.98 30.1%
AAPL 210.73 33.7%
GLD 107.31 20.8%
IBM 130.90 27.5%
MSFT 30.48 37.3%
MS 29.60 79.0%

 

Yet, there is another "volatility of volatility" to consider. The underlying for VIX options, as noted earlier, is the group SPX of options that will be used to calculate the exercise settlement value at expiration; that is, forward VIX. Historically, forward VIX has tended to be less volatile, on average, than the VIX index itself. In recent years, for example, the volatility of forward VIX (as measured by near-term VIX futures prices traded at the CBOE Futures Exchange) was significantly less than the volatility of the spot VIX. {2}


{1}  http://cmegroup.mediaroom.com/index.php?s=43&item=2994

{2}  http://www.cboe.com/micro/vix/vixoptionsfaq.aspx