VIX Futures - Trading the fear index

By: Aaron Fennell
Date: September 12, 2011

In recent years the VIX futures have progressed from being an obscure contract to become an important part of a modern trading toolbox. In 2004 the Chicago Board Options Exchange listed futures contracts on the Volatility Index. In essence the Volatility Index futures price expectations for volatility. The VIX futures are good tools to protect or insure a portfolio against abrupt or unexpected spikes in volatility. They can also be used to speculate on the direction of volatility. Modern and sophisticated traders should understand the mechanics of the VIX futures as they are powerful tools for portfolio management and are important indicators of market uncertainty.

The Volatility Index or VIX measures the amount of expected volatility implied by option prices. The Volatility Index uses the Black Scholes option pricing model as its cornerstone. The Black Scholes model was designed to calculate fair prices for options using a number of factors and assumptions. The model proved useful and quickly revolutionized the options industry and earned Fischer Black and Myron Scholes a Nobel Prize in Economics. Unfortunately the one shortcoming of the model is that it requires an accurate estimate for future volatility to arrive at an accurate option price. Making one estimate to come to a second estimate is a significant shortcoming and criticism of the Black Scholes model. However, the Volatility Index uses the model in the opposite direction. The index begins with the market prices for the S&P 500 options and with that calculates the volatility factor implied by those prices. The VIX calculation is driven by market expectations for volatility instead of being an arbitrary estimate. This index gives a measure of market expectations for how widely the market could potentially move. The higher the option prices the higher the volatility index. The VIX futures settle based on the calculation of that index at a specific point in time.

The long dated VIX futures prices tend to be slightly above the long term average level for volatility. When current volatility is below this historical average the volatility index futures will be upward sloping or the nearer months will be lower than months with more time to expiry. There is some optionality in the VIX futures pricing as traders can maintain long positions in the VIX futures to insure their portfolios against spikes in volatility. Given that there is an eroding benefit to being long the VIX futures if volatility does not spike the contracts will on average exhibit some properties of time decay. When volatility is low the futures with greater time to expiry have a greater possibility of experiencing a spike in volatility. When volatility does spike the front months will abruptly climb and the futures curve for the VIX will invert and the nearer months will be higher than the back months.

Currently the most interesting situation in the VIX futures exists around the December VIX contract. The December contract is trading lower than both the November and the January contracts. Typically one might rationally expect that the December contract should trade somewhere between the two neighbouring contracts. There really is not a compelling reason for the expectation of volatility in December to be lower than either the November or January expectations. Given the pace of change in the global markets it is really difficult if not impossible to determine exactly when volatility will spike or subside. Of course it may be that December volatility will happen by chance to be lower than either of the neighbouring months, but it is just as possible that volatility may spike in December and be lower in November and January. In this environment the expectation for volatility beyond a few weeks should tend towards to average expectation for volatility.

Traders can attempt to capture this anomaly with the use of a butterfly spread. This would involve selling 1 November VIX, purchasing 2 December VIX, and selling 1 January VIX. The position would neutralize exposure to the overall direction of volatility fairly well as 2 contracts in the strategy would be long and 2 would be short. If volatility remained high one would expect the VIX futures curve to remain inverted and the December should climb above the January. If volatility abruptly subsided one would expect the VIX futures curve to go back into a normal shape with November falling towards or below the December VIX. Overall the expectation is that the December VIX futures should move between the November and January prices over the upcoming two months.

If you would like to implement a VIX futures strategy either to hedge against spikes in volatility or to speculate on the direction of volatility you can contract the Fennell Thompson Group at 416-862-3945.

Disclaimer: Opinions expressed are subject to change without notice. This report should not be construed as a request to engage in any transaction involving the purchase and sale of a futures contract and/or commodity options thereon. The risk of loss in trading futures contracts or commodity options can be substantial, and investors should carefully consider the inherent risks of such an investment in light of their financial condition.