the diversification benefits of volatility russell rhoads, cfa instructor – the options institute

The Diversification Benefits of Volatility

Russell Rhoads, CFA

Instructor – The Options Institute

CHICAGO BOARD OPTIONS EXCHANGE

CBOE Disclaimer

Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of standardized Options. Copies may be obtained by contacting your broker or the The Chicago Board Options Exchange at 400 S. LaSalle St., Chicago, IL 60605.In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences.Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.


Trading Volatility

Summary –

• Introduction to the VIX Index

• Publicly Traded VIX Derivatives

• Diversification Studies

• Summary / Q&A


VIX Index

The VIX –

CBOE Volatility Index.

Measures S&P 500 implied volatility.

Based on S&P 500 Option bid/ask quotes.

Uses the nearby options with at least 8 days until expiration.

Has been promoted as a ‘fear index’ by the business media.


VIX Index

A Brief History of the VIX – 1993 – VIX introduced in a paper.2003 – VIX calculation changed.2004 – futures contracts introduced.2006 – options on VIX begin trading.2008 – binary options on the VIX.2009 – mini-VIX futures introduced.2009 – VIX ETN’s introduced.


VIX Futures

VIX Futures

• Value is $1000 x the level of the VIX Index.

• Trade the next 7 months of expiration.

• Expire on Wednesday 30 days before corresponding S&P 500 option expiration.

• Have very unique characteristics relative to other financial futures.


VIX Futures

Mini VIX Futures

• Value is $100 times the VIX Index.

• Trade the next 3 months of expiration.

• Expire on Wednesday 30 days before corresponding SPX option expiration.

• Have very unique characteristics relative to other financial futures.


VIX Futures

Pricing – VIX Future

August VIX – VXQ9 @ 26.90 = $26,900.Minimum price move = .05 or $50.+/- 1.00 price change = +/- $1000.

Mini-VIXAugust VIX – VMQ9 @ 26.90 = $2,690.Minimum price move = .05 or $5.+/- 1.00 price change = +/- $100.


VIX Futures

Expiration Months – VIX Futures

Next 7 MonthsCurrently – Oct, Nov, Dec, Jan, Feb, Mar, Apr

Mini-VIXNext 3 MonthsCurrently – Oct, Nov, Dec


VIX Futures

Unique Features –

Pricing is anticipatory, no ‘cost of carry’.

Future price reflects market opinion of the future direction of the spot VIX Index.

At times the VIX future price is higher than the index and at times it is lower.


VIX Futures

11.00

14.00

17.00

20.00

23.00

26.00

29.00

32.00

6/1/07 6/15/07 6/29/07 7/13/07 7/27/07 8/10/07 8/24/07 9/7/07 9/21/07

Index

Future


VIX Futures

22.00

25.00

28.00

31.00

34.00

37.00

40.00

43.00

4/1/09 4/15/09 4/29/09 5/13/09 5/27/09 6/10/09 6/24/09 7/8/09 7/22/09

Index

Future


VIX Futures

Expiration –

Futures expire 30 days before the next month’s normal option expiration.

Example – October VIX Futures

Expire Wednesday October 21.

Option Expiration is November 20.


VIX Futures

Settlement Pricing –

VIX futures are AM settlement with a special calculation of the VIX Index taking place the morning after the end of trading for a futures contract.

This is known as the Special Opening Quotation.


VIX Futures

Special Opening Quotation (SOQ) –

This is a unique VIX index quote that involves only actual S&P 500 option trades. The regular VIX Index calculation uses the mid-point between bids and offers.

The symbol for the SOQ is VRO.


VIX Options

Characteristics

• European style

• Unusual Pricing

• Wednesday Settlement

• Opening Price Quotation


VIX Options

European Style –

European options are only allowed to be exercised on expiration.

VIX options are cash settled at expiration.


VIX Options

Unusual Pricing –

It is not uncommon for VIX options to appear to be cheap or expensive when using the VIX Index as the underlying.

The proper underlying instrument should be the corresponding VIX future price.


VIX Options

Unusual Pricing –

VIX Index @ 22.00

VIX February 20.00 Call @ 1.25

VIX February Future @ 20.50!


VIX Options

Unusual Pricing –

VIX Index @ 27.50

VIX March 30.00 Put @ 1.50

VIX March Future @ 29.00!


VIX Options

Wednesday Settlement –

Just like the VIX futures contracts, VIX options expire on the Wednesday 30 days before equity option expiration.


VIX Options

Opening Price Quotation –

VIX Options are settled using the Special Opening Quotation on the morning following the last trading day for those options. This is identical to the settlement process for the VIX futures.


VIX Options

VIX Binary Options –

• Introduced in 2008.

• All or none payoff structure.

• European Style.

• Trade with the symbol BVZ.

• Three near term months are listed.


VIX Options

Binary Options – Payoff

Binary options pay the option holder $100 per contract if the option expires in the money.


VIX Options

Binary Options –

Call – payoff if the settlement price is at or above the strike price.

Put – payoff if the settlement price is below the strike price.


VIX Options

Binary Options –

Available for download on the CBOE Website is a report on Binary Options.

www.cboe.com/Institutional/reports.aspx


VIX ETN’s

VIX Exchange Traded Notes

• What is an ETN?

• Short Term Volatility - VXX

• Intermediate Term Volatility - VXZ

• Characteristics of these ETNs


VIX ETNs

What is an ETN?

ETN stands for Exchange Traded Note, it is an unsecured, unsubordinated debt security. They are created to replicate returns on an index minus fees. The trading in ETN’s is very similar to that in ETF’s (Exchange Traded Funds).


VIX ETNs

iPath S&P 500 VIX Short-Term Futures ETN (VXX) –

Gives investors exposure to a daily rolling long position in the first and second month VIX futures contracts.


VIX ETNs

iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) –

Gives investors exposure to a daily rolling long position in the fourth through seventh month VIX futures contracts.


VIX ETNs

Characteristics –

• Exchange traded on the NYSE

• Have a negative correlation to S&P 500 index returns

• Backed by Barclays Bank


VIX Diversification

• It has been shown that in times of market weakness the benefits of diversification diminish

• The VIX index has a negative correlation with the performance of the S&P 500

• There are several studies showing the benefits of exposure to a volatility asset providing diversification benefits to a portfolio


VIX Diversification

CBOE Study –

• Focused on 2005 - 2008 asset class performance

• Created a diversified portfolio using various exchange traded funds

• Added weightings to VIX futures to the model portfolios to determine diversification benefit


VIX Diversification

Emerging Markets -54%

International Developed -43%

Real Estate -43%

U.S. Large Caps -37%

Commodities -37%

U.S. Small Caps -34%

Hedge Funds -23%

Fixed Income 5%

2008 Performance by Asset Class

Source: Credit Suisse Portfolio Strategy


VIX Diversification

CBOE Study – Model Portfolio –

• 35% Large Cap – SPY

• 20% Small Cap – IWM

• 30% Bonds– 15% 7-10 Year Treasury Fund – IEF

– 15% 20+ Year Treasure Fund – TLT

• 15% Foreign– 10% MSCI EAFE Index Fund – EFA

– 5% MSCI Emerging Markets Fund - EEM


VIX Diversification

CBOE Study – Portfolio Returns

Year Diversified Portfolio SPY

2005 4.73% 3.01%

2006 11.16% 13.74%

2007 4.51% 3.24%

2008 -20.99% -38.28%

4-Year -3.87% -25.34%


VIX Diversification

CBOE Study – Portfolio Volatility

Year Diversified Portfolio SPY

2005 8.41% 10.33%

2006 9.90% 10.99%

2007 12.10% 15.86%

2008 23.90% 41.25%

4 Year 14.90% 23.29%


VIX Diversification

CBOE Study – VIX Enhanced Portfolios

Diversified

PortfolioVIX Enhanced Portfolio - 15%

VIX Enhanced Portfolio - 30%

Large Cap 35% SPY 35% SPY 35% SPY

Small Cap 20% IWM 20% IWM 20% IWM

Bonds 15% IEF 15% TLT

15% IEF 0% TLT

0% IEF 0% TLT

Foreign 10% EFA 5% EEM

10% EFA 5% EEM

10% EFA 5% EEM

Volatility 0% VIX Futures 15% VIX Futures 30% VIX Futures


VIX Diversification

CBOE Study – Enhanced Results

DiversifiedPortfolio



2005 4.73% 0.70% -2.57%

2006 11.16% 8.44% 5.42%

2007 4.51% 10.70% 16.84%

2008 -20.99% -13.08% -2.92%

4 Year -3.87% 5.07% 16.50%


VIX Diversification

Diversified

PortfolioVIX Enhanced Portfolio - 15%


4 Year -3.87% 5.07% 16.50%

Avg.Return -0.98% 1.24% 3.89%

Std. Deviation 3.03% 1.93% 2.14%

Sharpe Ratio -0.41 -0.31 0.07

CBOE Study – Enhanced Results


VIX Diversification

CBOE Study – Summary

• Study focused on using VIX futures exposure combined with traditional portfolios

• Adding exposure to VIX futures in a portfolio of diversified assets would have resulted in better absolute and risk adjusted returns from 2005 – 2008


VIX Diversification

University of Massachusetts Study –

• Studied the 2008 market and the diversification benefits of VIX futures or options.

• Compared a variety of portfolios and combined exposure to the VIX.

• Results showed return and diversification benefits of including the VIX in a portfolio.


VIX Diversification

University of Massachusetts Study –

• Looked at both VIX futures and options to provide exposure to volatility

• Has a systematic approach to using these instruments to hedge a portfolio

• Took a variety of portfolios and added VIX exposure to determine if there are diversification benefits


VIX Diversification

U Mass Study – Portfolio Construction

• 99% Equity / 1% OTM VIX Calls

• 97% Equity / 3% OTM VIX Calls

• 59.4% Equity / 39.6% Bonds / 1% OTM VIX Calls

• 58.2% Equity / 38.8% Bonds / 3% OTM VIX Calls

• Measured Mar 2006 – Dec 2008 and Aug 2008 – Dec 2008


VIX Diversification

U Mass Study – Mar 2006 – Dec 2008 Results

Annualized

Return

Annualized Standard Deviation

Annualized Sharpe Ratio

100% Equity -10.30% 26.85% -0.47

99% Equity / 1% OTM VIX Calls -3.29% 24.86% -0.23

97% Equity / 3% OTM VIX Calls 1.24% 39.99% -0.03

60% Equity / 40% Bonds -3.66% 15.39% -0.39

59.4% Equity / 39.6% Bonds / 1% OTM VIX Calls 2.64% 18.67% 0.01



VIX Diversification

U Mass Study – Aug 2008 – Dec 2008 Results

Period Return

Period Standard Deviation

Period Sharpe Ratio

100% Equity -27.87% 37.73% -0.74

99% Equity / 1% OTM VIX Calls 7.95% 34.96% 0.22

97% Equity / 3% OTM VIX Calls 84.41% 53.38% 1.58

60% Equity / 40% Bonds -15.87% 21.65% -0.74




VIX Diversification

U Mass Summary –

• Focused on 2006 – 2008 and Fall of 2008 to test diversification benefit of exposure to volatility for a variety of portfolios

• Most dramatic results came from using out of the money call options on the VIX as a small weighting of a traditional portfolio.


VIX Diversification

Summary –

• Currently there are three methods to take a position based on the future direction of the VIX.

• Studies show that exposure to these instruments results in improved risk / return characteristics for a variety of portfolios.


VIX Diversification

University of Massachusetts Paper –

Full study available on the CBOE website.

www.cboe.com/Institutional/reports.aspx


VIX Diversification

Summary –

The CBOE Website has more information on these and other products.

Questions / Comments?In Chicago and want to visit the CBOE floor?

[email protected]

the diversification benefits of volatility russell rhoads, cfa instructor – the options institute

Documents