What is VIX?

The CBOE Volatility Index (:VIX) measures the implied volatility on S&P 500 Index options with a 30 day forward expiration.  Widely termed the “fear gauge,” the VIX rises rapidly when stock prices fall, but declines when stock prices rise.

The Chicago Board Options Exchange (NasdaqGS:CBOE — News ) lists both call and put options on the S&P 500 Index.  These options vary across strike prices and expiration dates.  VIX is simply the average of the implied volatilities of all options listed in the two months closest to expiration.  Because the weight between the two expiration months changes every day to maintain a 30 day constant maturity, VIX is not directly tradable.

Options prices are often calculated using the Black-Scholes options pricing formula.  The variables that determine the option’s price is the time to expiration, strike price, index price, interest rates, dividends and volatility.  At any given time, all of these factors, with the exception of volatility, are known quantities.  In order to determine the level of volatility implied in the option’s price, an options calculator, such as that available at www.cboe.com/LearnCenter/OptionCalculator.aspx. is used.

The implied volatility is the market’s best estimate of the annualized standard deviation of the price changes of the stock market over the coming 30 day period.  From 1993 to 2011, VIX has ranged from below 10% to over 80%, but has been between 14.3% and 24.6% approximately half of the time.  While VIX averaged 20.8% over the last eighteen years, volatility has been significantly higher over the last three years, averaging 27.7% between 2008 and 2011.  When market volatility is expected to increase, such as during periods of corporate earnings announcements and political risk, options prices and VIX tend to increase.

While stock and options prices are not normally distributed, the normal distribution can be used to understand the implications of market volatility estimates.  For example, at 10% volatility, and the S&P 500 Index at 1300, the market is estimating approximately a 68% probability that the S&P 500 Index will trade between 1170 and 1430 one year from today, which is one standard deviation away from the current Index level.  At 30% volatility, the range of outcomes is much wider, with a 68% probability that next year’s stock market level will be between 910 and 1690.

How does VIX respond to changes in the S&P 500 Index?

VIX consistently shows a negative correlation to returns on the S&P 500 Index, averaging -0.63 since 1993 and -0.83 over the last three months.  A long position in VIX, then, is frequently used to hedge positions in stock market investments.  The volatility of VIX is very high, averaging 99% since 1993, while the volatility of the S&P 500 has averaged less than 20% over the same time period.  A little VIX, then, goes a long way, so investors are encouraged to trade VIX at a smaller size than their typical stock position.  Leveraged VIX products have an even higher volatility.

VIX rises rapidly when the S&P 500 declines, but falls more slowly when the S&P 500 rises.  While the hedge ratio can vary with the exchange-traded product, as well as over time, the front month futures may have a beta of -1.7 to the S&P 500 index, while second month futures may have a beta of -1.2.

What are the uses of VIX products?

Empirical evidence shows that VIX, and market volatility, are mean reverting.  This means that when VIX is at extremely high levels, it is likely to move lower, while it is likely to move higher when trading at extremely low levels.

Long positions in VIX are used to profit from increases in stock market volatility, which frequently happens when stock market prices are falling.  As such, long positions in VIX can be used to hedge a portfolio of stocks that are correlated to the S&P 500 index.  Long positions in VIX can profit from mean reversion when stock market volatility is at extremely low levels, such as below 20%.

Short positions in VIX are used to profit when the volatility futures curve is upward sloping, as well as to take advantage of the mean reversion characteristics of volatility.  When VIX is demonstrating high levels of stock market volatility, such as above 30%, VIX is more likely to trade lower rather than higher.

Underlying Contracts: Short-Term, Medium-Term, Dynamic, and Term-Structure

VIX ETPs typically track the performance of either short-term or medium-term VIX futures contracts.  The S&P 500 VIX Short-Term Futures Index rebalances positions daily between the two futures contracts nearest to maturity to maintain a constant one-month maturity.  For example, on January 1, the desired maturity is January 31.  This position can be reached through a combination of the VIX futures expiring on January 18 (53.5%) and those expiring on February 15 (46.5%).  There is a substantial trading cost in this strategy, as futures are traded each day to maintain the constant maturity.  Products tracking the VIX Short-Term Futures Index are typically more volatile than those tracking the VIX Medium-Term Futures Index.

The S&P 500 VIX Medium-Term Futures Index rebalances positions daily between the fourth, fifth, sixth and seventh month futures contracts to maintain a constant five-month maturity.  Products tracking the VIX Medium-Term Futures Index are typically less volatile than those tracking the VIX Short-Term Futures Index.

The S&P 500 Dynamic VIX Futures Index uses information regarding the degree of contango and backwardation across contract months to allocate between exposure to the Short-term and Medium-term Indices.  This index is designed to minimize the cost of contango or maximize the return to backwardation by trading at the most cost-efficient contract horizon.

Finally, the S&P 500 Futures Term-Structure Index is a long-short index with a 100% long position in the Medium-Term Index and a 50% short position in the Short-Term Index.  Due to its mixture of long and short positions, this Index is typically less volatile than either the Short-Term or Medium-Term Index, and is designed to profit more from contango and backwardation than from the outright movement in either index.

Fund Families Offering VIX Products

There are five issuers of VIX products, each with their own structure and offerings.

The earliest entry into the VIX exchange-traded products (ETPs) lineup is the iPath series of ETNs issued by Barclays Bank.  Starting with VXX, a long position tracking the short-term VIX futures, iPath has built the largest volume in the VIX exchange-traded product menu.  In December 2011, iPath ETNs traded an average of over 14.3 million shares per day, dominated by the 13.9 million share volume of their flagship product, VXX.

Launched on November 30, 2010, the second most popular provider of VIX ETPs is Velocity Shares, which are ETNs issued by Credit Suisse.  In December 2011, volume in Velocity Shares averaged over 8.8 million shares per day, dominated by XIV, an inverse product, and TVIX, which gives 2x leveraged long exposure to VIX.  Velocity Shares are designed to match returns of VIX futures on a daily basis.  Exchange-traded products with an objective of matching returns on a daily basis are not meant for long-term holding periods, as the return over long-term periods will not match the stated objective due to the compounding of returns.  A product designed to match 2x daily returns will not match 2x monthly returns.

ProShares has built respectable volume since launching VIX ETFs on January 4, 2011.  ProShares are unique in that the firm offers the only VIX-linked exchange-traded funds.  As stated earlier, ETFs segregate client assets, which are subject to the counterparty risk of brokers and exchanges, which has historically been considered to be of minimal concern.  The recent bankruptcy of MF Global is causing some investors to reconsider their view of the risk of funds held by futures brokers.  However, regulatory inquiries into the situation may better protect client assets from future bankruptcies of brokerage firms.  In any case, ETFs are generally perceived to have less issuer risk than ETNs, which are unsecured debt of the issuing bank.  In December 2011, the volume of ProShares VIX ETFs averaged over 500,000 shares per day.

Citi issued a single product, the CVOL C-Tracks ETN, on November 15, 2010.  In December 2011, this product averaged volume of just over 20,000 shares per day.   Designed to closely match the VIX Index, this product combines long exposure to the third and fourth month VIX futures contracts with a short position in the S&P 500 Index.

UBS E-Tracs, exchange-traded notes issued by UBS, started trading the flagship long-short product, XVIX, on December 1, 2010.  An additional twelve products were offered starting on September 18, 2011.  We will not cover these products (VXAA, VXBB, VXCC, VXDD, VXEE, VXFF, AAVX, BBVX, CCVX, DDVX, EEVX, and FFVX) as the most liquid of these ETNs averaged volume of less than 1,200 shares per day in December 2011, with many products trading zero volume on multiple days.  Volume in these twelve products, which offer either long or short exposure to each of the first six futures contracts, has declined precipitously, falling in volume by an average of nearly 80% from October to December 2011.  The volume traded in other VIX ETP families declined by just over one-third during the same time period.