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November 1, 2004

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

By Mark Longo

Unfortunately, two main problems had to be overcome before this new cash cow could be milked. The first was the arcane methodology used to calculate the VIX. This obscure methodology made the VIX an interesting theoretical tool, but rendered it practically useless for trading purposes. The second and most critical problem was that the VIX was merely an abstract index, not a product that could be marketed and sold to the investing public.

The first problem was handled through a complete overhaul of the VIX. Most buyside and institutional desks use the S&P 500 as a performance benchmark. They also use S&P 500 futures and options to hedge their portfolios against adverse market conditions. However, the VIX was calculated using S&P 100 volatility, a much narrower and far less useful index. In order to make the product more attractive to institutional and buyside traders, the CBOE recalculated the VIX using S&P 500 volatility.

The CBOE also made another important change to the VIX. Traders had been complaining for years that the VIX only took into account at-the-money volatility (volatility near the current trading price of the index). This made it difficult for the VIX to account for the dramatic shifts in volatility that occur as the index fluctuates across strike prices. The VIX was recalculated to take into account the volatility of a wide variety of strikes. These included the call and put wings, along with the at-the-money strikes. These two changes made the VIX a far more accurate representation of the overall volatility of the equity markets.

Futures Exchange

While these calculation changes were dramatic, they were meaningless without a product to back them up. On March 26, the CBOE created the CBOE Futures Exchange (CFE). This electronic futures exchange marked the options exchange's first foray into futures trading (aside from single stock futures, which is a subject for another column). The CFE's inaugural product was the future on the new VIX, prompting many in the industry to refer to it as the Volatility Exchange. While the Volatility Exchange has had several new products over the past few months (futures on the S&P 500's variance and futures on the China Index), VIX futures are still its primary product.

For buysiders who are considering using VIX futures, there are several things to consider. Before trading any futures contract, you should analyze the contract size and margin requirements to determine if they fit your portfolio needs. Also, since VIX futures are based on a broad market index, they are far more useful for hedging portfolio volatility than single equity volatility. You should also keep in mind that, like S&P 500 futures, you have to determine the proper hedge ratio between your portfolio and the VIX future.

If your proprietary software isn't up to that task, then you can use publicly available software systems. For trading purposes, any software that can interface with CBOE directly can also be used to execute trades on the Volatility Exchange.

Volatility futures have a great place in a trader's arsenal. Whether you work on a buyside desk, manage a large institutional fund or just sling stocks in your 401(k), any product that will finally let you sleep through the night is worth its weight in gold.

Mark Longo is an options trader and a former member of the Chicago Board Options Exchange.