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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: Today the CBOE Futures Exchange, LLC (CFE) will launch trading on CBOE NASDAQ-100 Volatility Index(SM) (VXN(SM)) futures contracts. VXN is a key measure of market expectations of near-term volatility conveyed by NASDAQ-100 Index (NDX) option pricing. The structure of the futures contracts is the same as those on the widely followed CBOE Volatility Index® (VIX). Initially there will be only four consecutive monthly contracts listed which differs from VIX futures which have contracts with expirations trading for the next nine months.
The NASDAQ-100 Index is an index that tracks the most active domestic non-financial stocks trading on the NASDAQ Stock Market based on capitalization. The NDX is often considered an indication of the performance of technology stocks as about 2/3 the composition of the index is technology related companies. The table below shows the biggest stocks in the NDX. These 10 names represent well over 50% of the capitalization of the NDX.
Since the VXN is derived from NDX option pricing the relationship between NDX and VXN is worth exploring. There is daily closing pricing for the VXN available for several years on the CBOE's website. Using this data I took a look at how the VXN trades relative to NDX and VIX. The results were a bit interesting and may be a good guide to a basis for trading VXN futures.
As expected the relationship between the NDX and VXN is similar to the relationship between the S&P 500 and VIX. That is there is a distinct inverse relationship between the two. The chart below shows the NDX versus the VXN for 12 months leading up to the end of April 2012. The inverse relationship that appears in this chart is pretty typical of the relationship between NDX and VXN over any time period.
Comparing the daily changes of NDX and VXN from January 1, 2004 through April 30, 2012 results in a correlation of -0.73198, which is very close to that of the SPX and VIX. The correlation for this time period for the SPX and VIX is -0.75335. Many traders consider VIX futures a proxy for trading an outlook for the overall stock market. VXN futures should be considered a tool to trade an outlook for the NDX index, much like VIX futures may be used when traders have an outlook for the S&P 500.
As a bit of caution -- VIX futures move in the same direction as the underlying index, but often do not move with the same price magnitude. As a prime example of this sort of price action, check out these mid-day quotes of the VIX index and the first four trading months from mid-day on Tuesday May 22. The VIX is down 0.75 on the day and each of the next four futures contracts is down as well. However, the contracts are down less than the spot VIX. This trading behavior for VIX futures is typical when the VIX index moves higher or lower up and down and is unique to VIX futures trading. Although just listed, VXN futures may trade in this manner as well. Of course, time will tell.
Major market indexes that follow US stocks tend to move in tandem. The NDX and SPX have this sort of relationship. The correlation between NDX and SPX is 0.9544 which indicates the two move very close to each other. Because the NDX and SPX track each other so closely, checking out the relationship between the VIX and VXN is worth taking a look at. The chart below shows the VIX and VXN relationship between VIX and VIX for the twelve months leading up to April 30, 2012.
This VIX and VXN tracked each other very closely over this period of time. Looking at data going back to 2004 these two volatility indexes have a correlation of 0.8953. It may be difficult to see on this chart, but about 90% of trading days the VXN trades at a premium to the VIX. The table below breaks the relationship between VXN and VIX down on a yearly basis going back to 2004.
Note there are years where the VXN is always at a premium to the VIX. However, looking at the last four rows of the table the relationship between the VXN and VIX has been pretty stable. Thinking of the spread as the VXN minus the VIX the spread has been positive more often than not. If the futures contracts follow a similar pattern, spread trading opportunities between SPX and NDX volatility using VIX and VXN futures will certainly emerge.
Directional trading with VXN futures or spreading VXN versus VIX futures are just a couple of potential uses for these new volatility futures. I plan on watching the activity and seeing what else pops out at me as these futures gain some traction. If you have some thoughts feel free to shoot me an email at firstname.lastname@example.org or leave comments here.
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