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November 1, 2004

Volatility Into the Future: Traders Piggyback Software That Links Directly to the Exchange

By Mark Longo

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  • Volatility Into the Future: Traders Piggyback Software That Links Directly to the Exchange
  • Page 2

Frequent readers of this column in Traders Magazine know how I enjoy

poking fun at the absurd level of competition in the options marketplace - six major financial institutions fighting over table scraps. Still, this creative destruction sometimes produces surprising results. Last month I highlighted the new and improved linkage system among the exchanges. Now come derivatives products aimed at institutional traders. These products are called VIX futures, which give you the power to trade volatility in its purest and most terrifying form.

The VIX, or Volatility Index, is not new. The other talking heads in the financial press have been mouthing about it for years. They often refer to it as the Fear Index, because the VIX measures the near term at-the-money volatility of the S&P 100.

Since the S&P 100 is a broad market index, the VIX is seen as a good surrogate for the overall level of fear in the marketplace. If the market takes a downturn, the Fear Index rises and vice-versa. However, while the VIX makes good headlines in the financial press, it has little practical use as a trading tool.

But that all changed at the end of last year. There is a new twist. I can still remember the moment when I heard the news. It was a crisp fall day. I was sitting in my office, staring at my trading screens when the phone rang. It was a reporter looking for a quote. "What do you think about the new VIX?" she asked? Her question stunned me. Could it be true? After so many years of complaints from the trading community, were they finally going to fix the VIX? What she said next completely blew me away. "Yes, they're revamping the VIX. And when they're done, you're going to be able to trade it."

That was a watershed moment in the derivatives world. For decades, traders had been scrambling for ways to hedge their portfolio's volatility without the complications of equity and index options. The new VIX futures would allow them to do just that. Volatility would become one more risk that you could hedge to lock in trading profits. Most shocking, these seminal products were the byproduct of the brutal battle between the options exchanges.

As everyone in the business knows, the Chicago Board Options Exchange was the market leader in options volume for decades. But, in recent years, competing exchanges like the International Securities Exchange and the American Stock Exchange have taken significant portions of their equity options volume. As a result, the CBOE has been forced to rely even more heavily on its index options to maintain revenues. The CBOE's most successful index products, the SPX and OEX, were safeguarded from predatory competition by an exclusive licensing agreement with Standard & Poors. The success of these licensed products prompted the exchange to examine its holdings for other exclusive licenses to exploit. With its prominence in the national media, the VIX was an obvious choice.

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