TCS Daily

VIX Vapor Rub

By Dominic Basulto - March 3, 2006 12:00 AM

In his 1933 inaugural address, Franklin Delano Roosevelt famously remarked, "The only thing we have to fear is fear itself." Seventy-three years later, there is nothing to fear -- including fear itself.

On February 24, the Chicago Board Options Exchange (CBOE) officially started trading options on its volatility index (VIX), the first product on market volatility ever to be listed on an SEC-regulated securities exchange. The new financial instruments -- known as VIX Options --essentially enable market participants to hedge or speculate in the options market based only on their views of future investor sentiment. Since the VIX is commonly known as the "fear gauge" among Wall Street investors, investors are essentially able to trade options based on their estimation of the amount of "fear" in the marketplace.

The VIX, which measures the market's expectation of S&P 500 volatility implicit in the prices of S&P 500 options, is watched by options and stock traders as an up-to-the minute market estimate of expected near-term volatility. In layman's terms, volatility is defined as a measure of the rate and magnitude of the change in prices, so it's easy to see why the VIX is known as the "fear gauge" and considered to be one of the leading barometers of investor sentiment and market volatility. While the current level of the VIX is less than 13, during times of heightened market fear, the VIX may spike to levels between 50 and 75. During times of catastrophic fear, the VIX may reach levels well above 100.

Of course, investors have been able to trade options on a variety of underlying financial instruments (i.e. stocks and indexes) for some time. In addition, futures on the VIX already trade at the CBOE Futures Exchange (CFE), but this will be the first time investors will be able to hedge or speculate in the financial markets based on their views of volatility using options. On the first day of trading, investors embraced the new VIX options with some circumspection, as they digested the uniqueness of the new financial instruments. On February 24, approximately 4,400 calls and 6,000 puts on the VIX changed hands on the CBOE.

As Josh Hendrickson pointed out in an earlier TCS piece ("Snow Job"), financial markets have been increasingly embracing opportunities to create new financial instruments for investors eager to hedge away certain types of risk. In the example cited by Hendrickson, the Chicago Mercantile Exchange recently announced plans to offer futures contracts for seasonal snowfall in New York City and Boston. The natural buyers of these contracts would be hedgers such as city governments (which would want to hedge away the costs of having roads salted and plowed during snowstorms) and weather-sensitive companies such as retailers and ski resorts, which also face the prospect of economic losses as the result of high or low snowfall levels.

Viewed against this backdrop, the new VIX options on the CBOE continue the trend toward enabling new ways of hedging against risk in the marketplace. According to the chief options strategist at Oppenheimer & Co., for example, these new VIX options could become natural "disaster hedges" for market participants concerned about steep one-day market declines. Heavy buyers of VIX options would likely be investors concerned about catastrophic event risk (e.g. Al-Qaeda terrorists blowing up a number of major Saudi oil refineries, disrupting global oil supplies and panicking stock traders).

The rationale behind the "disaster hedge" scenario is based on the fact that the VIX tends to move in a highly correlated negative relationship with the broader stock market (i.e. the S&P 500). When stocks rise, the VIX falls; conversely, when stocks fall, the VIX usually rises. For mathematicians keeping score at home, there is a 0.78 negative correlation between movement in the S&P 500 and the VIX. On the 26 days that the S&P 500 fell by 3% or more during the period 1990-2005, the average price change of the S&P 500 was -3.8%, while the average price change of the VIX was +16.8%. On the flipside, on the 33 days on which the S&P 500 rose by 3% or more during this same time period, the average price change of the S&P 500 was +3.9% and the average price change of the VIX was -9.2%.

Going forward, it will be interesting to watch broader market adoption of similar tools for managing risk, hedging exposure and even speculating on future events. Already, the CBOE is working on a number of other instruments, such as small-sized event-driven "binary options" for retail investors. (Heads it happens, tails it doesn't) For now, the ability to trade pure market volatility (i.e. "fear") could lead to interesting conversations at water coolers across the nation: "Why are you feeling so gloomy today -- did you wake up on the wrong side of the bed? Yeah, but I made a lot of money doing it."

Dominic Basulto is the editor of Fortune's Innovation Insider.



And for the Positive Correlation..Gambling disguised as High Finance
As interesting as these (and similar) novel instruments are, they represent speculation on outcomes of natural and human events. If I were the mob, or one of those constituencies dependent on the Powerball, I'd be worried, the Wall Street Crowd was muscling in on my territory.

I'll bet more than some of these exotic derivatives traders, minus the suit, the MBA or advanced Math degree, would be giving the Raiders plus or minus something on crisp fall afternoons.

VIX Options - Changing the Investment Landscape
Although respecting the previously posted comment, I sincerely disagree. All financial markets are the result of speculation on natural and human events. Humans run the businesses and respond to natural events in the market place that detemines the value of the companies. Humans place bids and offers for these stocks and bonds and determine their prices based upon a human's assessment of value. The VIX options that are listed on the CBOE are no different.

The VIX options and futures will provide skilled institutional investors, who invest money for pension funds, college endowments, foundations, and ordinary people like us, with a tool to enhance risk-adjusted returns. The key to this enhancement is the negative correlation between the level of volatility and equity prices that the author was so adept at highlighting.

The fundamental concepts of contemporary investment management trace their roots back over 50 years, and have resulted in numerous Nobel Prizes. Now the investment profession has a tool to embrace these legendary tenets of risk-adjusted returns by adding a negatively correlated asset to a diversified portfolio of stocks. In my opinion, the listing of VIX options and futures will be the most significant event of the decade for the investment business.

Congratulation to the author, whose thorough and accurate discussion of VIX options will lead those investment managers truly interested in their client's well being, down the path of further investigation into this revolutionary product.

Bud Haslett, CFA

Define Investment
You say you disagree, but why?

I'm not suggesting that security be pulled or that its morally tainted. What I am suggesting, hyperbolically, is that the definition of security seems to be migrating more and more from the share of economic entities to shares in derived assets whose value may or may not AFFECT such a thing and the line between investing and speculation is now a blur.

More importantly, I was an ERISA/IRC analyst for Qualified Plan compliance between 1992 and 1999 and am now again consulting on a small DB plan. I learned just how "skilled institutional investors" created the Orange County debacle of 1994, that eventually led to the trust requirements for "eligible" 457 (b) plans required by the Small Business Job Protection Act of 1996.

With all due respect, if the institutional investors were so skilled @ their craft, we wouldn't be seeing all these underfunded plans-AND JUST WAIT, because soon the state and local governments will have to disclose their unfunded liabilities.

Few if any plan administrators understand these instruments and as much as I respect the CFA credential, the quant jocks that dream this stuff up are in the mathematical stratosphere-and many people-including skilled institutional investors-are way behind.

Superheater (I prefer the freedom of anonymity or I'm chicken), MBA, CPA, CLU, ChFC, FLMI/M

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