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By Lawrence G. McMillan 

Source: CBOE Futures Exchange -- The CBOE Volatility Index (VIX) is accelerating in its downtrend. This is likely bullish for stocks and reflective of the strong stock market rally in the S&P 500 Index (SPX) that has taken place so far this year. Not only has the market rallied, it has done so in a very straight-line fashion with small daily ranges. This type of action lowers actual (also called statistical or historical) volatility, which in turn is reflected in a decrease in implied volatility (VIX). Some are becoming worried that VIX has fallen too far, too fast; a somewhat valid argument. This argument could be offset with just a minor market correction, not necessarily a full-blown market downturn.

Meanwhile, the VIX settlement process this month produced some highly unusual action. Figure 1 shows the entire history of the monthly VIX settlement prices since the inception of VIX futures trading in May 2004 (trading first began in March 2004, and the first contracts that settled were the May 2004, futures). The symbol for the monthly settlement price is VRO. The SPX is also overlaid on the graph. While there is not a perfect (inverse) correlation between SPX and VRO (and, by inference, VIX), one can see the general tendency of the two to move in opposite directions.

VIX Settlement

This month, VIX settled at 23.64, which is slightly up from the previous month. The January VIX futures expired in an "a.m." settlement on Wednesday morning. The special expiration value of VIX (VRO) is computed by using the opening trades in the SPX options. January VRO was based on the opening prices of all SPX February options on Wednesday morning (or, if there is no opening trade, then an average of the first posted bid and asked prices is used).

In recent weeks, VIX has generally been acting in a manner consistent with a bullish outlook for stocks. It has generally been declining and has had trouble rallying, even when stocks sell off. When stocks began to rally again, VIX began to drop. Thus, the long downtrend that (see Figure 2 later in this report) has taken place after many days.

This pattern was in existence on Tuesday, January 17th (the first trading day of this week), until about 2:30pm Eastern time, when the January VIX derivatives had only 90 minutes of trading life remaining. Suddenly, VIX began to rally even though SPX was up that day. By the close, VIX had risen over a point; its high for the day.

Then on expiration (Wednesday), the stock market opened flat and began to trade higher while VIX exploded to the upside, opening at 23.44, 1.24 above Tuesday's close. VRO opened even higher at 23.64, the price at which the January VIX derivatives would settle. This is a large move, even if the broad stock market was lower (it wasn't). In addition, as noted above, VIX has not been able to rally when the stock market declines, and certainly not when it's up.

Once the prices were marked for the January settlement, VIX began to rapidly decline. It fell precipitously and kept falling, closing at 20.89, about 2 1/2 points lower than its opening price. While continuing to plunge, it closed at 19.87 the following day, and 18.28 the day after that. The only time that VIX rallied was immediately before expiration; otherwise, a steep decline in VIX was in place before and after. The graph in Figure 2 shows the intraday spike in the VIX at that time.

What happened here? I really do not know. If the market had been sharply selling off, I might be able to justify why VIX shot higher on settlement morning, but that was not the case.

Premium and Term Structure

Table 1 shows the state of the VIX futures term structure on January 20th. The term structure has become even more extreme in its bullishness: the futures are all trading at premiums to VIX, and the term structure slopes very steeply upward. The futures contracts expiring in May and later have extremely large premiums near or above 8 points.



Once again, demand remains heavy for protection. Strategies that involve selling VIX futures (or buying puts on them) offset a position that is short the stock market (short S&P 500 futures or long put options on SPX, SPY, or S&P 500 futures, etc.) and are viable hedges.

The main problem with the strategy right now is that there is no certainty that the premiums will shrink right away. Given the somewhat overbought nature of the stock market, this strategy still offers a good risk-reward balance.

A riskier more speculative strategy would merely be to buy some out-of-the-money near-term VIX calls, figuring that a reflex rally is due.

New Product: VXEEM futures

The CBOE Futures Exchange (CFE) has launched a new volatility futures contract on the iShares MSCI Emerging Markets ETF (EEM). The accompanying volatility index is calculated from EEM options and is listed under the symbol VXEEM. The futures on that index trade with a base symbol of VXEM. Currently there are March, April and May futures trading. If you recall, since the initial listing of VIX and Variance futures on the CFE, the only other futures to be listed were the CBOE Gold ETF Volatility Index Futures (GV) last year. Those gold volatility futures have practically no trading volume, as interest was very minimal. However, the new VXEM futures have already traded with a modicum of volume. The front-month March contract has open interest of 118 contracts, with 71 in April, and 22 in May. Of course, that's minuscule compared to VIX futures, but you have to start somewhere.

As with VX futures, the VXEM futures are worth $1,000 per point of movement. They also expire on the same Wednesday morning as VIX futures. The VXEM futures are based on the next series of EEM options that expire 30 calendar days after the VXEM futures expire (just as VX futures and options are). At this point there are no options on VXEM futures, but it is likely that there will be in time.

Current prices (settlement on 1/20/2012):

  • VXEEM: 26.07
  • March future: 32.85
  • April future: 33.95
  • May future: 34.15

As you can see these futures are trading at a premium to their volatility index (VXEEM) and the term structure slopes upward too. They have the same meanings as VIX futures and It may be a bullish sign for the EEM to have this derivatives construct.

International traders have followed the European volatility index (VSTOXX) and its futures to glean information about European stock movements, similar to what we in the U.S. find in VIX derivatives. These new VXEEM derivatives may prove to be useful in that regard as well, especially since U.S. markets appear to be sensitive to movements in foreign markets at times.

Source - CFE Futures in Volatility