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Russell Rhoads is an instructor with The Options Institute at the Chicago Board Options Exchange. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies and is the author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics. Russell also wrote Trading VIX Derivatives: Trading and Hedging Strategies using VIX Futures, Options and Exchange-Traded Notes. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois - Chicago and acts as an instructor for the Options Industry Council.
Russell: The CBOE has been hard at work developing new measures of volatility and methods to trade an outlook on market volatility. You can now trade futures contracts based on an outlook for implied volatility on the S&P 500, iShares MSCI Emerging Markets Index (EEM), iShares MSCI Brazil Index (EWZ), the price of Gold based on the SPDR Gold Shares ETF (GLD) and the price of Oil based on the United States Oil Fund (USO). Three of those indexes are stock market related and two are based on the prices of physical assets. The table below lists out the details for each of the related volatility indexes.
I took a look at the price behavior of these various volatility indexes and was a bit surprised at the results. The next five charts show the daily closing prices for the VIX, VXEEM, VXEWZ, GVZ and OVX relative to their underlying markets from 4/1/2011 - 3/30/2012. Scan through and notice something that is similar for all but one.
VIX - SPX
VXEEM - EEM
VXEWZ - EWZ
GLD - GVZ
USO - OVX
All of these volatility index charts have a similar characteristic with one exception. Over the 12 months shown in these charts there is an inverse relationship between the underlying market and implied volatility of the options on those markets on all charts except for the chart of the GLD ETF versus the GVZ. If it did not jump out at you check the correlation statistics below.
Note, not only is there not a negative relationship between the GLD and GVZ, it is actually fairly positive over this time period. So what is it that makes volatility on gold act a little differently than the other types of volatility? The answer comes with the nature of option trading on these types of markets. Consider the reason behind the behavior of the VIX relative to the S&P 500.
The VIX and S&P 500 have an inverse relationship that goes back for years. This relationship stems from the nature of S&P 500 index option trading. First, the SPX option arena is one of the few where there is consistently more put volume than call volume. SPX put option contracts are a favorite hedging vehicle for investment managers looking for portfolio protection. The demand for SPX puts (that is buying versus selling) tends to increase when investment managers feel they need this protection the most.
For GLD option contracts the volume weighting has been more to the call side as of late. The reason for this trading behavior may be due to a specific concern regarding higher gold prices or as a hedge against potential inflation. For whatever the reason, the risk in gold seems to be to the upside. When the market has had big moves in gold and the GLD exchange traded fund in the last few months it has been in both directions, but the more aggressive reaction in the option market has been to buy calls on up days and not necessarily puts on down days.
Because of the way the VIX is portrayed in the popular press, the impression is that implied volatility for all markets moves higher when the underlying moves lower. Aggressive buying of calls on bullish days that causes implied volatility to move higher has become counter intuitive, regardless of the underlying market. However, at least over recent history, it appears that implied volatility for options on the GLD ETF has been doing just that.
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