" The CBOE Volatility Index (www.cboe.com) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, has been considered by many to be the world's premier barometer of investor sentiment and market volatility." *
In the media, theis often referred to as the "fear" index. It spikes during times of crisis and market chaos. The index has a strong negative correlation to equity prices and reacts to events in other asset classes as well.
In the last decade, thehas evolved from an indicator to an active and liquid vehicle. Globally, more volatility trades through -based derivatves prodicts than any other financial instrument. Because futures and options trade openly in the secondary market the pricing od these products is transparent. This results in faster price discovery, greater liquidity, and markets that are more efficient than the OTC products that preceded them.
Those interested in understanding or intoducing volatulity into their portfolio as an asset class shoild understand the mechanics ofbased producsts and how to best execute multi-product vega based strategies.
Theindex estimates the value of a one month variance swap on the SPX index and represents the market's expectation of volatility over the next month. The price of the is derived from the value of a basket of SPX options. It measures the risk level priced into the equity volatility market and offers distinct advantages to using at-the-money SPX volatility.
derives its value directly from the prices of listed options on the SPX. Therefore does not depend on any model assumptions.
The index always measures one month implied volatility. As a results, it is particularly useful for comparing implied volatility regimes.
The index does not refer to any particular strike in the SPX but to the whole volatility surface. It allows a direct comparison between two different time periods even if the price level of the SPX is significantly different.
On any given day, estimates the volatility of the next 30 calendar days.
For example, if first month SPX Car expires in 15 days and is 30 vol and second-month SPX Var expires in 45 days and is 33 vol, it follows that a weighted average of these values calculated around 30 days equals 31.5 vol. This is the value of the.
The always measures implied volatility over the next 30 calendar days. However, most market volatility is realized on business days and not weekend days. Consider that you are looking a the index on a Friday (June 10). The next 30 days have 20 business days and 10 weekend days. However, on Monday, June 13 the next 30 days have 22 business dyas and 8 weekend days. On Friday the proportion of business days in the is lowest. On Monday, the ratio of business days on the index increases. Therefore, the total amount of volatility implied by the -as measured over the 30 calendar days beginning on Monday - increases as well. Consequently, the trends lower on Friday and higher on Mondays.
- Term Structure
You can think ofexpiration much like SPX options expiration. Recall that for SPX expiration an investor must trade a basket of 500 stocks that represents the index on the opening print. This transaction replicates both the risk and the price level of the investor's expiring options or futures.
Similarly, if an investor is long (or short)futures, they can trade a basket of SPX options on the CBOE to offset the expiring exposure.
futures and options settle 30 days prior to the next month's SPX expiration. At expiration, the index is composed of only one month's SPX options prices. It is precisely at the same time that the exact price level of the can be replicated by this basket of options.
Since everyFuture refers to a specific time period, the CBOE has listed contracts with multiple expiration dates. Currently, the CBOE lists the next seven months futures. In a normal market environment, term structure is generally upward sloping. This implies there is less uncertainty in the near term versus the long term.
While thesettles to the price of variance on expiration, the futures represent the value of forward starting variance. In an upward sloping term structure, the futures will generally trade at a higher price than a variance swap with the same expiration.