In Part 1 of this primer, I dissected the Chicago Board Options Exchange's proposed strategies for using the new VIX future and illustrated some potential problems. However, that doesn't render the product completely useless. In fact, it can create some interesting opportunities for astute traders.
Here, I'll tackle some common questions about the VIX future and discuss five ways you can use it once it hits the market on March 26. Can the future be used to gain pure implied volatility exposure? Volatility traders (as opposed to directional traders) of S&P 500 index options derive profits from two components: a change in the implied volatility and realized volatility captured by hedging their positions. This future only calculates the change in forecast implied volatility and will not reflect any captured (realized) stock-price movement. This is a critical point to understand before considering this product's "pure implied volatility." Implied volatility may be a large factor in long-dated options, but it's relatively insignificant in the front months used in the VIX. Realized volatility is the primary factor of profitability in front months. Front-month straddle buyers generally buy for the event, not the post-event change in implied volatility. Options held to expiration will only be profitable if the realized volatility is greater than the implied volatility initially paid -- or, put more simply, hedging profits will be greater than the price paid for the options. Investors buying the actual S&P 500 index options will be able to capture that movement while future buyers will not. Can the future be used to hedge against short-term options positions? VIX futures aren't a reliable hedge for this usage. Here's an extreme example of how the suggested hedge (short options, long future) could exacerbate losses. Last July 24, Roche acquired Igen International. Igen's stock price jumped from $37 to $59, while the implied volatility collapsed from 80 to 30. A trader selling an August 35 straddle for $6 would have lost about $18. Volatility decreased because the price of the acquisition was fixed, and the stock was now expected to be stable. Future buyers would not only fail to participate in the positive stock movement, but also lose money because the implied volatility fell. This type of loss is unpreventable with the future.
What's the correlation between the VIX and its future? The VIX and the future are not very correlated and will trade independently of each other. If there are anticipated market-moving events in the next 30 days, the future will trade at a discount to the VIX. This is because the future will settle against next month's VIX, which will reflect post-event levels. So how can I use the VIX future effectively? Here are five possible ways: Reduce nonfront-month vega exposure, but not gamma exposure. Futures can be used to reduce vega risk before the anticipated event (target) month (i.e., short November options and long October future). However, if the event occurs before the future settlement date, you might lose on both sides of the trade. Speculate on the level of implied volatility at a specific point in time. Investors can use the future if they believe general volatility will increase after a quiet period. Partially offset the vega of long-dated options and convertibles. It can be used to partially reduce exposure without the transactional and operational costs of dynamically hedging a position. There is a term (time) mismatch, and it's not a highly correlated hedge. Hedge volatility risk between announcement date and issuance date of a structured product. Speculate purely on post-event changes in volatility without regard to the stock-price movement. For example, investors may believe implied volatility will decrease 5 points after a key Fed announcement, but do not want the exposure to a potentially adverse movement. The uniqueness of this product will create some profitable situations. As with any launch of a new product, it will take some time for the VIX future to be properly priced. Understanding its strengths and weaknesses will provide an edge when it first opens for trading.