Is a VIX of VIX Too Many Derivatives?
By Sarah Rudolph
Last week at the FIA conference in Boca Raton, the Chicago Board Options Exchange announced a new CBOE VIX of VIX Index (VVIX) that measures the volatility of the CBOE Volatility Index (the VIX index). The VIX index itself is a measure of the market’s expectation of future volatility implied by the prices of options on the S&P 500 stock index.
Who are the likely users of the index? Anyone who trades volatility products or watches the VIX index, according to Catherine Shalen, director, research and product development, for CBOE. “It is a natural offshoot of the VIX; it uses the same methodology but applies it to a new asset class.”
Currently, there are no futures or options traded on or planned for the VVIX index, according to Shalen. It can be used as an indicator, in particular to capture volatility risk premium for those who trade a portfolio of VIX options. VVIX measures the price of a portfolio of VIX options, just as the VIX measures the price of a portfolio of S&P 500 options, she said. The CBOE has noticed that, historically, if you sell the portfolio on a consistent basis, you can expect, on average, to earn a volatility risk premium.
Mark Wolfinger, a former CBOE market maker and author of The Rookie’s Guide to Options, said he thinks the new index will be a success for the CBOE because of the volatility of the VIX index, but said he expects the VVIX to be used mostly for speculation rather than hedging, and he prefers to think of options as a hedging tool.
He also opined that novice traders might get confused by the fact that the index is a derivative of a derivative of a derivative of a derivative (The Wall Street Journal called it “Fear Squared.”)
“If you want to use VVIX as a hedge, it’s really an estimate of the expected volatility of the forward price. It can get complicated. So some sophistication about volatility products might be necessary to use the index properly.”
The VVIX reflects the market’s consensus of expected volatility of the 30-day forward price of the VIX index, according to the CBOE’s press release.
Wolfinger said he was concerned that if people don’t pay enough attention they might believe incorrectly that the CBOE uses the SPOT VIX and determines how volatile it has been over a given period of time, in order to determine the VVIX.
Randy Frederick, managing director of active trading and derivatives at Charles Schwab, echoed Wolfinger in wondering if the index would be too complicated for some investors.
“People got in trouble when VIX options were introduced; they didn’t understand they weren’t tied directly to the VIX index, but rather to futures on the VIX. I think people make that mistake every day. I tell them make sure you go to CBOE’s web site and read an explanation of how VIX options work.”
Frederick saw one particularly valuable use for the new index, however. “You can display an implied volatility study on top of the chart of the actual VIX, but it may not be accurate. The problem is the charts only know how to create a study based on an underlying index. The challenge is that the underlying index isn’t really the underlying of the options, the futures market is the underlying of the options. So you end up with an odd-looking study that makes it look as if the price of VIX calls is significantly higher than VIX puts,” he said.
The new VVIX properly looks at the futures, he said. “You could overlay the VVIX index on top of a VIX chart and, if it is done properly, you will be looking at the VIX futures, so it will be an accurate depiction of the implied volatility of the VIX.”
Shalen does not think the index will be difficult to understand for those who follow volatility, but she agreed that when it comes to trading, the VVIX will be of interest primarily to institutional traders. “For big investment banks and people who model volatility, the volatility of volatility is a very familiar concept,” she said.
As far as hedging versus speculating, “any financial product can be used for both hedging and speculating,” she said. “If you have hedgers, you need speculators to take on the risk. Even if you have hedgers on both sides, you still need speculators.”
However, anyone watching the forward price of the VIX index will be interested in seeing a market view of how volatile those prices will be in the near future, she said. Traders of VIX options should be interested in the VVIX, because it measures the volatility that drives those options prices, Shalen said.
“It also tells you how the market views the range of VIX at the expirations of VIX futures and options – will it be narrow or wide, for example.”
Interest in the CBOE’s volatility product has been growing rapidly in the past few years, so the time was right to introduce the VVIX index, Shalen said. “The VIX index was around for many years before we even had any products on it. We had to wait until there was enough of a class of traders who trade VIX-based products, and now we have it.”