Stuart Barton I November 6, 2017
With so much interest in VIX linked Exchange Traded Products (ETPs) like VXX, XIV, and SVXY, etc., I thought it might be worth putting some of these products into context, and explain why their growth might have less to do with volatility trading and more to do with a unique facet of the VIX index.
By way of background, I have made my career as a volatility trader. In 2000 I joined a large investment bank in London, trading what was then one of Europe’s largest volatility trading books. I later established a similar business for that bank in New York, and soon became one of the largest options and variance swap market makers in the US. That business grew rapidly and went on to launch the first volatility ETP – the VXX. Since then I have helped launch several more VIX ETPs and now manage volatility portfolios for individuals, institutions, and other advisors.
Over the years the market for VIX ETPs has grown tremendously, and daily volumes of the most popular products sometimes exceed $1BN each. This impressive volume has drawn so much media focus that it is sometimes easy to forget that VIX ETPs fit into the broader volatility market. To help remind us, it may be useful to discuss what volatility trading is, and how it came about in the first place.
Volatility, in the financial sense, describes the movement of an instrument’s price rather than the actual price itself. Any instrument whose price moves exhibits price volatility, and volatility trading is trading the expected future volatility of that price. Volatility traders are therefore less interested in whether a price goes up or down, and more interested in how much and how frequently the price might move.
The first, and still most popular, way to trade volatility is to trade options. The price of an option is determined by several factors including expected future volatility – usually called implied volatility. If all of the pricing factors excluding implied volatility are hedged, the trader can be left with a naked implied volatility position, and as implied volatility rises, the price of the option rises. This volatility/price relationship is referred to as Vega.
Stock options have been actively traded on organized exchanges in the US since 1973, greatly aided by the pricing methodology presented by Fischer Black and Myron Scholes in their article ‘The Pricing of Options and Corporate Liabilities’. In essence Black and Scholes catalyzed the options market by demonstrating how an option could be priced as a function of interest rates, dividends, stock price, and implied volatility – ultimately offering us the opportunity of trading implied volatility.
I won’t delve further into options pricing here, but if you are interested in reading more, two of the most important books on the subject are John Hull’s ‘Options, Futures, and other Derivatives’ and Sheldon Natenberg’s book ‘Option Volatility and Pricing’. I’ve put a more complete reference in the footnote.
In addition to stock options, index options have seen tremendous growth over the last 30 years. In 1983 the CBOE launched the S&P 100 index (Ticker: OEX) specifically to facilitate index options trading, and at the same time listed options on the existing S&P 500 Index (Ticker: SPX). For many years options on the OEX were far more liquid than the SPX, and as we’ll see later, it was the OEX that the VIX Index first referenced.
To put the size of this market into context, below is a graph showing the growth in SPX options since 2001. In dollar terms, an SPX option has a multiplier of $100, so if we use an average index value of say 2,100, the average daily volume in 2016 of 1,023,623 SPX options amounts to almost $215 billion of notional per day. This is an astounding figure. Remember the dollar value of VIX ETPs trading on any one day is typically less that 2% of this notional.
Added to this extraordinary trading volume in SPX listed options is the additional contribution made by the Over The Counter (OTC) market between banks and their clients. Notoriously difficult to quantify, think of the OTC market as the wholesale market for options where brokers, traders, and customers - usually on bank trading floors or on telephones - deal directly with one another.
Until recently, the options market was dominated by the CBOE’s SPX pit, pictures of which no doubt you’ve seen where brokers shout at market makers to get their client’s orders filled. But today the vast majority of this SPX flow trades electronically, even though a smaller SPX pit still exists. The OTC market has also slowed down considerably since the financial crisis, with new regulation imposing capital requirements on bilateral trades, and clients becoming less comfortable taking a bank’s or prime broker’s credit risk. This is a huge change from the pre-2007 OTC market where banks would confirm billion dollar trades with little more than ‘DONE’ shouted down a squawk box and a short fax from someone in the back office.
In addition to the options market, an active OTC market exists for variance swaps. Simply put, a variance swap is a contract between two parties where the seller promises to pay the buyer the realized variance (the square of volatility) over the 'strike' price at the swap’s expiry. I won’t go into the details here, but if you’re interested please read my article ‘How VarSwaps Work And Why Knowing Is Important’.
So how does the VIX fit into all of this? Well, the important thing to remember is that this listed and OTC volatility market forms the backbone of all the VIX products that exist today. An option on the SPX is a derivative on the SPX, the VIX index is a derivative on those options, or a derivative on a derivative – something I like to call a D squared (D^2).
The CBOE created the VIX or Volatility Index in 1993 as an indication of the market’s expectation of equity index volatility. And this is important to remember, in 1993 there was no thought of creating an investable index, but rather a quick reference indicator that traders could follow. Originally the index was calculated from the price of OEX options, which at the time were by far the most heavily traded index options in the world. This was changed in 2003 to reference the SPX after option volumes exceeded those in the narrower OEX index. The VIX has gone through a couple of further iterations since then, but first it is worth discussing how it is calculated.
In the simplest terms, the VIX can be thought of as a market consensus of how much the SPX is likely to move over the next 30 days – expressed as an annualized standard deviation. I.e., a VIX index value of 10 represents an expected annualized range of 10% up or down in the S&P 500 index over the next 30 days at a 68% confidence level, or one standard deviation. On a daily basis this implies a daily range of 0.63%, calculated as the annual range (10%) divided by the square root of the number of trading days in a year (normally around 252). So 10% / √252 = 0.63%.
The CBOE’s calculation of the VIX is quite complicated, and I won’t go into more detail here, but for those wanting to read further I recommend this article by the CBOE. In summary though, the VIX Index is calculated by averaging the weighted prices of a basket of out-of-the-money SPX puts and calls to calculate an implied volatility of the SPX for the next 30 days.
And this is why the index is not tradable. While most indexes reference a static basket of underlings and implement periodic rebalances, the VIX index references a dynamic basket of out-of-the-money options that is constantly changing with the spot price. If the basket change was just a function of time passing, then dynamic basket replication would be possible, but because the strike of the options chosen in the basket is also a function of the spot price of the SPX (and its volatility), the maintenance of the dynamic basket is simply impossible. Proxy hedges can be created that may work well for short periods, but once the SPX moves, or implied volatility changes, the basket changes and the hedge deviates from the index.
To be fair on the CBOE, the index was not initially designed to be investable and changes to the index over time have helped better integrate the index into the existing volatility ecosystem. But given its present design it will never be tradeable.
As a tradable alternative, the CBOE launched VIX futures in 2004. Using my nomenclature from before, VIX futures are a derivative of the VIX index meaning these are D^3s. Like futures on commodities or stock indexes, the VIX futures settle against their underlying on their specified expiry date. But unlike other futures, because the VIX index isn’t tradable, there is no ‘cash and carry’ arbitrage available between the index and its futures. Let me give you an example. In the gold market the futures price can be calculated from the present tradable spot price of gold, interest rates, and storage cost, and this relationship allows for arbitrage between the cash and futures market that keeps the two trading in a tight arbitrage band. Not so in the VIX market. Because no arbitrage between the index and the futures is available, VIX futures prices are much more independent of their underlying than are other futures, and it is for this reason a true futures risk premium can exist between the VIX index and its futures.
And it is this facet of the VIX that underlies today’s growing interest in volatility ETPs that track or hold VIX futures. I won’t go into the mechanics of how these popular ETPs work, but I recommend Vance Harwood’s excellent articles, two of which I include links to here and here. Suffice it to say, VIX based ETP are actually VIX futures based ETPs and are therefore exposed to the futures risk premium as well as the VIX index.
When we first discussed an exchange traded volatility product almost 10 years ago, the consensus at the time was that the bulk of the interest would be from fund managers looking to gain long exposure to equity volatility as a type of portfolio hedge. And to be fair, this was probably the case in the early years of the VXX. There was then very little expectation that retail investors would be interested in what is effectively a D^4 - or derivative on a derivative on a derivative on a derivative.
But over the years things have changed. Today a great deal of interest comes from a very different group of market participants who are trading in the opposite direction to the one we had predicted. Retail investors and hedge funds are shorting VXX and/or buying the inverse ETPs like XIV and SVXY to access the futures risk premium that I highlighted above – a risk premium that conveniently exists because the VIX index itself is untradeable.
Looking back, the growth in this trade is hardly surprising. Over the last five years the XIV for example has delivered almost 500%, putting short VIX futures products on most sophisticated trader’s radars. But will this risk premium continue to exist? Well arguments are being made both ways, but it certainly still exists today and has existed for most days this year. And for this reason interest continues to grow.
But outright static short positions in VXX or long positions in XIV or SVXY might not be the best risk adjusted approach to access this futures risk premium. VIX ETPs continually hold or track a dynamic portfolio of VIX futures, but hold these futures (either long or short) irrespective of whether the futures risk premium is positive or negative. For example, if the VIX futures term structure is upward sloping - as it is at the time of writing this article – long VIX ETPs like VXX would likely decay as they paid away a daily futures risk premium, making an investment only profitable if the underlying futures increased enough during a volatility spike. The opposite applies to the inverse products like XIV and SVXY, holding them on days when the VIX futures term structure is flat or inverted exposes the investor to the risk of a volatility spike without the benefit of the futures risk premium the investor is seeking to harvest.
To date there is still no VIX ETP that actively manages its exposure to the VIX futures risk premium. However, in June 2017 Invest In Vol launched the Balanced Volatility Strategy to harness this premium in a Separately Managed Account (SMA). For some of the many advantages of SMAs I recommend my previous article ‘Investing in Volatility and the Advantages of Separately Managed Accounts’.
The Balanced Volatility Strategy offers individuals, advisors, and funds a simple investment for harvesting this popular risk premium. Account minimums are low and opening an account is quick. Invest In Vol is a Registered Investment Adviser (RIA) regulated under the US Investment Advisers Act of 1940 and specializes exclusively on managing volatility linked investments.
 Black, F. and Scholes, M., 1973. The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), pp.637-654
 Hull, J.C. 1999. Options, futures, and other derivatives. Prentice Hall. Natenberg, S., 2014. Option volatility and pricing: Advanced trading strategies and techniques. McGraw Hill Professional.
 Reuters 2014, Key dates and milestones in the S&P 500's history. https://www.reuters.com/article/us-usa-stocks-sp-timeline/key-dates-and-milestones-in-the-sp-500s-history-idUSBRE9450WL20130506
 S&P 500 Index Options – SPX, 2017, Available at: http://www.cboe.com/products/stock-index-options-spx-rut-msci-ftse/s-p-500-index-options
 Interactive Brokers, XIV Nov 1, 2012 to Nov 1, 2017 close to close returns 478%.
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