When assessing actual exposure in the market, why does the listed world use measures of implied volatility?
The standard in the OTC market, by contrast, is the variance swap – a contract where the payoff is in terms of actual movement in the underlying (“realized volatility” if you will). He says the OTC market is doing it right, in that participants are hedging actual market exposure with actual price movement, rather than expectations of future price movement.
Pending Securities and Exchange Commission approval in the next few months, BOX Options Exchange will begin exclusively listing VOLS, options on a realized volatility index based on the SPDR S&P 500 Exchange Traded Fund (SPY ETF). These cash-settled options will reflect the daily closing values of the SPY over a 21-day trading period per VolX’s RealVol Daily Formula.
Is VOLS meant to be a VIX alternative? Krause sees VOLS as a different kind of animal, and that there is room for both. He says VOLS are the best of both worlds, as each contract begins its trading cycle as an implied contract (called its “anticipatory period”), but once it enters its 21 day calculation period, the contract will mirror the RealVol SPY Index, which is a rolling realized volatility of the closing price of the SPY ETF.
Krause likens VOLS and VIX to a trip from New York to Los Angeles, with a stopover in Chicago. “They start out in tandem,” he says. “But when we get to Chicago, VIX drops off and VOLS keep going.”
Has the time come for the listed world to embrace realized volatility? BOX and VolX clearly have their work cut out for them. First and foremost, shifting attitudes away from an established standard, as the VIX clearly is, would seem a tall order. The deal between CBOE and S&P Dow Jones Indices, which in 2013 extended the exclusivity on VIX and VIX-related products until 2031, limits the ability of others to use the main indexes as reference prices, which is one of the reasons VOLS is using the ETF version.
Furthermore, this is not the first attempt at a realized volatility contract. CBOE, for example, began listing S&P 500 Variance Futures in December 2012, and Eurex recently launched a variance contract on the EURO STOXX 50, but neither contract has garnered trading interest. VolX itself is 0-for-1 in products based on its methodology. In 2011, CME Group launched FX VolContracts, 1- and 3-month realized volatility contracts based on CME Group’s Euro Currency futures.
While contracts fail for all kinds of reasons – bad timing, inadequate support from exchanges and poor contract design to name a few – Krause points to two in particular. In general, variance contracts have a margin inefficiency built into the methodology. He also says, in the case of FX VolContracts, they were never able to overcome the “classic chicken-and-egg dilemma.” Though market makers stood at the ready to provide as much liquidity as the market desired, they held back and waited for orders to materialize. Meanwhile, participants waited to see actual volume and open interest before jumping in.
Yet, atop the new product viability checklist are a robust cash market in the underlying and a pool of natural hedgers, two things that clearly exist in the world of realized volatility. The trick is to get participants to recognize that fact.