Volatility, VIX & The Weeklys

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(previously published on LinkedIn)

by Jack Fonss

The range of volatility products has continued to grow since the launch of VIX futures, but greater product choice has not necessarily simplified volatility trading. Most active traders continue to find the volatility market more idiosyncratic than other markets. Quick jumps, reversals, and VIX’s range-bound properties all mean that volatility analysis and trading differ from more conventional markets.

The presence of conventional-looking features in the volatility market such as spot levels and futures markets make it tempting to analogize to other asset classes – however, unlike other asset classes, S&P500 volatility may be more like a collection of separately and loosely related sub-markets rather than a single market.

Historically, volatility trading tools have been aligned with their direct application to options trading and options hedging (with a focus on 30 day and longer expirations). The CBOE Weeklys initiative will change the users and the applications of volatility tools. While the most often cited benefits of the CBOE Weeklys are higher-delta and more responsive contracts, I believe that the Weeklys are also a new direct market for near term volatility – because we now have a good tradable surrogate for the elusive cash volatility, we can now have the widest range of traders participating in price discovery.

What Makes Volatility Unique?

Most commodities and financial instruments have spot and forward levels which look similar to VIX curves (albeit the VIX curves are usually more pronounced).

Further, most commodities and financial instruments share the property that a barrel of oil (or share of stock) is fungible across time – once one accounts for factors such as storage costs, interest rates, and dividends, the barrel (or share) bought or sold today is translatable and convertible into the same barrel (or share) transacted in a forward market.

In contrast, volatility in different timeframes (e.g. 1-week spot, or 1-week 3 weeks forward) have no simple linkage – volatility underlying an index or contract is temporal and generally linked to a specific 30-day period now or in the future. The “temporal specificity” of a particular volatility is more like rainfall or temperatures within a specific month, and less like XYZ Co. stock which can be bought or sold spot or 30 days forward.

What Might the Addition of the Weeklys Deliver?

Even though the settlement values of the Weeklys are entirely based on the specified options chains, Weeklys trade independently from the options underlying the VIX values. I expect much of the Weeklys’ volumes will be transacted by portfolio hedgers and traders positioning to enter and exit equity index positions.

There are lots of estimations regarding the expected correlation (of daily returns) and term structure (of price levels) between the Weeklys and the cash VIX. By my rough estimation, the return correlations since last October (the launch of options on the Weeklys), exceeds 0.90. Early and rough estimates of the 1 week term structure (i.e. percentage term structure curvature over 1 week) are approximately 3%; when one factors in that futures-to-spot measured at and around futures expiry is ~ 1.5% (that is, even when time-to-expiry is practically zero, futures prices tend to fall ~ 1.5% over cash values), a “real” average 1-week term structure can be estimated to be between 1 and 2 percent. Even with light volumes, I believe that the Weeklys have already delivered on their goals.

An underappreciated benefit from the introduction of the Weeklys may be increased choice for volatility product users. Even though most of the volatility product landscape is dominated by 30-day forward/30-day volatility underlyings (seemingly simple), operations of these products usually force a rules-based daily trading regime which complicates timing and positioning for the uninitiated. The addition of Weeklys may present opportunities to deliver simpler exposures.

Of course none of this is a recommendation to buy or sell Weeklys or anything related to the Weeklys. But, I do recommend that those interested in volatility market structure closely follow developments in this space.