Volatility Rising

May 12, 2006

VIX options volume soars, as traders and hedge funds alike embrace the new contracts; 150,000 contracts trade in a day.

More than 150,000 contracts tied to the Chicago Board Options Exchange (CBOE's) VIX Volatility Index traded hands on Wednesday, May 10, smashing the previous record of 61,000 contracts set on May 1.  The surging volume is remarkable considering that the contract only launched in late February; most derivatives contracts take years to establish real liquidity. CBOE Vice President Matt Moran, however, is not altogether surprised.

"There's been incredible interest in the VIX index for quite a while," said Matt Moran.  "Long before the options launched, I received unsolicited calls from investors and brokers, saying, 'Hey, when and how can I trade the VIX?"

Now they can … and they are, in increasing numbers. Consider this: The average daily volume in April was 15,000 contracts; through the first 10 days of May, it is 51,000 contracts.  How's that for growth?

Call-ing All Investors

Moran said that by far the bulk of the volume is being executed in VIX call contracts, with comparatively little action in VIX puts.  On May 10, for instance, 146,000 call contracts traded hands, compared to just 4,200 put contracts.

It's impossible to know precisely why such a dramatic skew exists, but we can guess.  Many traders and investors view the VIX as a hedge against market turmoil, an idea that is strongly supported by the data. Over the past 15 years, there have been 26 days when the S&P 500 fell more than 3 percent.  On those 15 days, the VIX has risen, on average, by more 16.8 percent.

As a result, some people have taken to calling the VIX a "catastrophe hedge" - the one thing that can save your portfolio if the world goes bad in a hurry. From that prospective, people are attracted to the VIX calls to protect their portfolios from trouble.

Of course, for every long side of an options trade, there is a short side as well - someone who has agreed to write those calls and shoulder the risk. Moran says that these investors are probably trying to capture the income premium associated with the VIX contract.  The Volatility Index, he points out, is itself volatile, with a historical volatility of about 83 percent.  The VIX options contract actually comes closer to tracking the performance of the VIX Futures contract, which has a historical volatility that is closer to 46 percent … but still, that's much higher than the S&P 500 (10.3 percent) or even a high-beta tech stock like Google (32.1 percent).  As such, the people selling calls on the VIX are pocketing a fair amount of income for the trade.

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