The launch of one of the most highly anticipated financial products will take place Friday, when trading begins in the Chicago Board of Options Exchange's volatility futures. Although the concept of volatility-related investments is becoming more widely known, related products and trading has remained a domain occupied by a niche of professionals. But as I discussed in a
recent article, the important step was establishing volatility as a distinct asset class and making it widely accessible to the investing public. While pros and hedge funds have been trading "variance contracts," these are mostly custom-made products where the transaction occurs "upstairs" between two willing parties. Volatility futures will be the first market that uses a true open-price discovery system. A pair of articles last week by RealMoney contributor Paul Haber provided an excellent analysis of volatility index (VIX) futures. He not only discussed the futures' applications but exposed their limitations, including such intricacies as the ability to hedge front-month vega (the rate of change of an option's value relative to a change in volatility) but not gamma exposure (the rate of change of an option's value per unit change in the price of the underlying stock or index). It may also be useful to wade in from the shallow end of the pool and make sure we have a broad picture before it starts trading. It also means that if the VIX rises 1 point to 21, the VXB's value will increase from 200 to 210, and one VXB futures contract will gain or lose $1,000 per 1-point move in the VIX. Be aware of the leverage involved with futures -- it cuts both ways.
The VXB will have quarterly expiration months of February, May, August and September, plus two near-term months. So it will launch with May and July also active. The contract expires on the Tuesday before the third Friday of the expiration month (three days before the underlying index options expire), and will be cash settled.
For example, a rise of 10% to 20% in the S&P 500 would greatly reduce the value of put options as they move further out of the money, greatly diminishing the protection provided. But the value of the VIX, and by extension the VXB, may only dip slightly throughout the index's climb. So when a decline occurs, your cost basis, or starting point for protection, may only be a few percentage points different than your purchase price. A study published by Merrill Lynch showed that a simulated portfolio comprised of 10% VXB and 90% S&P 500 stocks would outperform the index every year since 1986 by 5%, while cutting the risk by 25%. Of course, this negative correlation works best when there is a dramatic drop in price. A slow, steady decline might not provoke a rise in implied volatilities, leaving the futures contract without any gains. And this protection doesn't come without a cost. Expect the futures to begin trading at a premium to the VIX because the index's current level -- at 20% -- is still near the low end of its historic range, with the growing perception that volatility is due to rise. Until there is enough acceptance of the product, I doubt many will be looking to short aggressively the futures given the current levels. If the futures initially are awarded a 10-point premium for the next month (210 in the VXB vs. 20 in the VIX) and nothing occurs to drive volatility higher when the contract expires and values converge, there will be a loss of $1,000 per contract. Of course, this is a very basic overview of how the VXB might function and there will be plenty of nuances, quirks and implications to learn before it can be most efficiently applied and traded. We will watch and learn.