What is the Arbitrage Driven Range for VIX Futures?

Wednesday, January 29th, 2014 | Vance Harwood
 

The VIX style calculation for the March 22nd SPX options closed today at 17.06.  The data is from the CBOE’s VIX Term Structure website.

CBOEVIXTS29Jan



The CBOE will use the March SPX options to compute the settlement value for the February VIX Futures when they expire on February 19th.

February VIX futures, on the other hand closed at 16.25, a 5% discount to the March SPX options.  The blue dot on the chart marks the VIX style calculation for the March SPX options.

VIXCentral29Jan14



Normally VIX Futures trade at a 3% to 9% premium to the VIX style IVs of the SPX options that will be used to settle them.

Futures-vs-SPX-VIX



This implies to me that profitable arbitrage of VIX futures using SPX options requires a  difference between the two of around +-5% or more.  Anybody have any insights on this?

For more background see: VIX Futures—Crystal Ball or Insurance Policy?



VIX Futures—Crystal Ball or Insurance Policy?

Monday, June 3rd, 2013 | Vance Harwood
 

Many people seem to believe that the CBOE’s VIX Futures market is attempting to predict upcoming CBOE VIX® values.  I think they are mistaken.   Most futures prices have very little to do with predicting the future.

Futures contracts were invented to allow producers/consumer of commodities to limit their business risk by locking in future prices.  In exchange for eliminating price risk they give up the potential for increased profits if markets later moved in their favor.  Traders wasted no time using futures for speculation, not because they somehow foretell the future, but rather because the low margin requirements for futures allows them to heavily leverage their bets.

Prices for futures contracts are constrained by arbitrage.  For example, if an arbitrager sees the premium for Dec 2013 E-mini S&P 500 futures rise above a certain point they will short E-mini contracts and buy the appropriate amount of stocks in the S&P 500 (or just short SPY).  From this point on they don’t care what direction the market moves—they are perfectly hedged—a risk free position.  The transaction is triggered when there is sufficient difference between the current S&P prices (the “spot” price) and the December contract bid price to compensate for their cost of capital to buy the stocks, account for dividends, and deliver the target profit.  Alternatively, if they think the futures price is too low, they reverse the transaction, buying the future and shorting the S&P 500.   Companies will differ in how much premium they require between the spot price and the futures price but the net effect is that E-mini prices trade between these boundaries—they aren’t a divination of the S&P 500’s value in December 2013.

For physical commodities like corn or natural gas the cost of storage is included in the futures pricing and in some cases seasonality.   For example, prices for corn might be depressed during harvest time because some producers want to move the product directly to market so they don’t have to store it.

Arbitrage for VIX futures is a much trickier thing.  You can’t buy volatility on the spot market and store it in your garage for a few months.  The best you can do is buy or sell the appropriate set of S&P 500 (SPX) options—the ones that expire 30 days after the settlement date, and eventually subject yourself to the settlement process.  Settlement is via the tweaky Special Opening Quotation (SOQ) process, which can’t even tell you ahead of time the full set of options that will be used for the settlement and in the last year has differed from the VIX opening price by as much as +4.27% / -3.8% on the morning that VIX Futures settle.

Contiguous SPX options are only available for the next 4 or 5 months, so the options associated with further out VIX futures expirations (up to 9 months out) are sometimes not even available.   Clearly market makers in VIX Futures must have other ways to hedge their positions (e.g., VIX futures spreads, VIX options, calendar spreads of SPX options).  In fact with the recent CBOE announcement of plans to start VIX futures trading 5 hours earlier than the current 8:15 ET, to coincide with European trading hours it appears they don’t even need the S&P 500, SPX options, or the VIX  to operate their market—at least for a few hours.

A quick look at historical data suggests that VIX futures tend to trade at a 3% to 9% premium to the VIX level of their associated SPX options.  A chart with April 10, 2012 and April 11, 2013 data is shown below:



Since the notional value of the SPX options market is currently much bigger than the VIX futures value it is reasonable to assume that the VIX futures tail does not wag the SPX options dog.   So the question becomes, what sets SPX options prices, and indirectly their implied volatility?  Are the market participants seers or are there other factors at work?

First of all, by any measure SPX option implied volatility is terrible at predicting future volatility in any way other than general reversion to mean.  If current volatilities are very low they predict an increase in volatility, if really high they predict it will drop.  Short term they predict that tomorrow will be like today—brilliant…

Insurance is a better model for predicting SPX option prices.  Investors use option strategies for price protection (e.g., fully hedge any market moves below a certain price), and as assets that reliably go up during serious market corrections or panics.  Even if your puts aren’t in-the-money, they still go up a lot when volatility spikes.

An insurance company doesn’t try to predict when you will have losses on your house or car.  It looks at the statistics and then charges a constant monthly rate they believe in aggregate will cover the claims they receive and over time deliver a reasonable profit.   I think the VIX Futures market looks a lot like an insurance provider.

Two final notes:

  • VIX Futures do have one seasonality pattern —the Christmas effect.  Typically December VIX futures are slightly cheaper than the surrounding contracts because volatility around that time tends to be low—a lot of people are on vacation, and the market is closed for several holidays
  • The VIX Futures term structure chart during quiet markets has gotten more linear in the last couple of years.  This shift has dramatically increased the contango in the mid-term futures—much to the chagrin of the XVIX, VXZ, and XVZ ETNs. On the other (inverse) hand ZIV is a happy camper.   Eli, from VIX Central speculates the curve straightened because there used to be a low risk trade of shorting a VIX future month right before it started sliding down the steeper portions of the curve, while being long the month after it as a hedge.  This trade might have just gotten crowded or perhaps the increased volume in the later month futures driven by the volatility ETPs made the market more competitive.

 



A 3D View of the S&P 500: Price, Time, and Markets

Tuesday, February 26th, 2013 | Vance Harwood
 

There are lots of valid ways to look at the market.  Obviously price is important, but a number alone (e.g., 1487.85—Feb 25th‘s S&P 500 close) doesn’t mean much.  Price related metrics like percentage changes and support/resistance levels add value, but adding time as a factor enables some really interesting measures like moving averages and momentum trackers.    My favorite time related metric is term structure—how the prices of various options and futures vary depending on their expiration dates.

February 25th‘s market action provided a very interesting set of views.

On the price dimension the percentage moves of the S&P 500 (SPX) and the CBOE’s VIX® index were unusual.  At 3:41 EST the SPX was at 1497.7 down 1.21% from the previous close.  The VIX on the other hand was up 26.7%, which was -22X the SPX move.  The average move is -4.77%, so this was a tad unusual.

On the time dimension the term structure of SPX options was moving rapidly into backwardation—the implied volatility of the near term options climbing dramatically compared to longer dated options.

At open:



At 3:26 EST:



Options in general and SPX options in particular are thought to be traded by more sophisticated investors and institutions.  This sort of term structure change indicates they were buying option based protection like mad—even though the market had only fallen 1.21% at the time.

The third dimension that I like to watch is how different markets react to the same set of circumstances.   At 2:44 EST the VIX futures market was still unimpressed with the SPX price action of the day—with the term structure looking almost ruler straight.



The March front month VIX future was only up 5.4% even though the VIX was up 16.7% at that point—and almost equal to the 3rd month future price.   The term structure looked a little different at market close.



It shows a dramatic shift into backwardation.

Although VIX futures are also linked to SPX options, the linkage is pretty weak.  The front month futures only reliably align with SPX options once a month—on the future’s expiration date.  Far fewer investors trade VIX futures and they are likely more sophisticated than SPX option traders.   Clearly the VIX futures market at 2:44 EST was much less impressed with the general market pullback than the SPX options market.

By market close the VIX futures market was serious about the market move, but judging by the position of the VIX close above the 6th (!) month VIX future value the VIX futures market is still not that worried.

The chart below shows the situation at close on February 26th:

VIXCentral.com

VIXCentral.com

 

The VIX dropped 11% and although lumpy the VIX Futures term structure straightened out.  For at least 26th the VIX Futures crowd called it right.



Short Term VIX Futures Growing 43% per Year—At Least

Friday, June 29th, 2012 | Vance Harwood
 

Last week the CBOE’s VIX futures set some new volume records.   While volume is interesting, I think the real story is the open interest of VIX futures contracts.  Is the volume just churn, or are VIX futures contracts being created or eliminated?   Since raw volatility is tough to buy, VIX futures market makers must buy other things, like SPX options to hedge the VIX contracts they create—so there is the potential to influence other markets.

The chart below shows the open interest and volume of the combined first and second month short term VIX futures from their beginnings in 2004.

Short Term VIX Futures Open Interest and Volume



Open interest has dropped a bit from the record levels in the spring, but it’s still running about double the 2011 levels.

The next chart shows the individual open interest in the first and second month contracts compared to the sum of the two.

Open interest of M1 & M2 Short Term VIX contracts plus sum of the two



The intertwined saw tooth shapes of the two individual months are the footprints of volatility ETPs like VXX, TVIX, and UVXY that must roll around 5% of their portfolios ($125 million currently) from first month contracts to second month contracts at the end of every day to maintain a constant time horizon on volatility.

With nearest month VIX futures running around $20K approximately 6,000 first month VIX futures need to be sold by the ETP vendors, 15% of the daily volume of around 40,000.    The chart below shows the open interest and the difference between the VIX index and a short term constant maturityVIX futures metric that doesn’t have roll costs.

 

Open interest and 30 day constant maturity M1/M2 – VIX



While hitting an all-time highs when the open interest peaked in March 2012, the gap between the VIX and the VIX futures has been in the normal historical ranges after that—the market doesn’t look unduly stressed by the current open interest/volume level.

What stands out to me, looking at the chart below, is the ongoing exponential growth that the short term VIX futures have demonstrated over the last 8 years.  If anything their growth is accelerating above their historic 43% annual growth rate.

 

Exponential Growth of VIX short term futures

 



Barclays’ VXX—Not as Short Term as You Think

Thursday, June 28th, 2012 | Vance Harwood
 

In terms of assets Barclays’ “S&P 500 VIX Short-Term Futures” ETN is the leader in volatility ETFs currently with $1.6 billion under management.   I suspect it’s also one of the leaders in investor confusion.

Although VIX is in its formal name VXX doesn’t actually track the CBOE’s VIX index with any degree of precision. In fact it’s not unusual for VXX and VIX to move in opposite directions for a day or two.  VXX can’t directly follow the VIX index, because nobody has figured out a way to cost effectively make a market in the VIX index.  The best that can be done is to invest in VIX futures—which tend to have a mind of their own.

VIX futures come in monthly series that expire the 3rd or 4th Wednesday morning of each month.  The next VIX future series to expire is called the first or near month and its settlement value is determined by a special calculation that closely corresponds to the opening quote of the VIX index on expiration day.   This is the only linkage between all the various series of VIX futures to the VIX index—a once a month synchronization point with the just expired future.  It’s much worse than a stopped clock—which is right twice a day.

Just holding contracts for one futures expiration month at a time would give VXX a variable maturity.  To provide a constant maturity Barclays executes a daily roll of first and second month contracts, gradually reducing the number of first month contracts until they are all sold right before they expire.  Barclays describes this process as providing a “constant weighted average maturity of one month.”

This is really misleading.

The VIX index tracks “the market’s expectation of 30-day volatility.”  It computes this using a weighted mix of options that are at least 7 days from expiration plus longer dated options.

When the near month VIX futures contract expires it closely matches the VIX index value—the 30 day estimate.  But on that day VXX has 100% rolled over to the successor VIX futures contracts that have another 30 calendar days before they expire—so VXX is really providing a weighted maturity volatility expectation of 60 days, not 30.

A longer effective maturity would at least partially explain VXX’s tendency to move about 50% of the VIX index daily moves on average. Longer term volatility expectations are less volatile.

To verify this analysis I created a spreadsheet that computes average maturity for VIX futures using linear interpolation/extrapolation of the futures prices.   Since this does not require modeling the buying / selling of VIX futures contracts there are no distortions due to contract rolls.

The chart below shows the historical volatility (22 trading days) of the VIX index compared to the historical volatility of VXX and my synthesized mix of first and second month (M1/M2) VIX futures that I believe corresponds to a 60 day expectation of volatility.

VIX, VXX, and 60 day M1/M2

 

My synthesized values match up well with VXX’s actuals.  It is interesting that VXX’s huge yield roll costs don’t show up in this chart.   The average of VXX’s historical volatility since January 2009 has been 58%—compared to 102% for VIX.

Next I shifted my synthesized mix of M1/M2 futures to closely match the true 30 day expectation of VIX.

VIX, VXX, M1/M2 for 30 day estimation of volatility



My simulation uses a linear extrapolation of the VIX term structure, rather than an exponential match, so I expected extreme volatility events to be understated.  But in quiet times the match between the VIX index and my true 30 day maturity mix of VIX futures is often quite good.

I think Barclays’ stated “constant weighted average maturity of one month” is a month shy of reality, and I’d like to see that changed in their literature.  This product is confusing enough without misstating the duration of its volatility expectation by a factor of two.