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26 (de) vizualizări8 paginiVolatility trading hedge

Feb 26, 2015

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Volatility trading hedge

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Volatility trading hedge

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The steady growth of CBOEs volatility complex provides a unique opportunity for

investors intent on capturing the volatility premium. The volatility premium is the risk

premium that the market seems willing to pay to own realized or implied volatility. The

prevalent conjecture among financial economists is that the volatility premium is

explained by the negative correlation between S&P 500 volatility and S&P 500 returns.

The volatility premium has always been reflected in the difference between implied and

realized volatility, and it now has become apparent in the historical returns of short

positions in CBOE Volatility Index (VIX) and variance futures.

To benchmark the returns of short volatility strategies, CBOE has developed two

different types of indexes. The CBOE S&P 500 VARB-XTM Strategy Benchmark

(VTY) is based on selling realized variance while the VIX Premium Strategy Index

(VPD) and Capped VIX Premium Strategy Index (VPN) are based on selling implied

volatility proxied by the VIX. The capped version of the VIX Premium Strategy Index

limits the risk of a short VIX exposure with long out-of-the-money VIX calls.

To clarify the difference between the VPD and VPN and the VARB-X Benchmark, note

that the VPD and VPN strategies involve selling a succession of one-month VIX futures

while the VARB-X strategy involves selling a series of three-month realized variance

futures. The VPD and VPN create a sequence of short exposures to forward one-month

S&P 500 implied volatility while the VARB-X creates a sequence of short exposures to

spot S&P 500 3-month realized variance. This implies that the VPD and VPN are

inherently more volatile than the VARB-X because implied volatility risk stays constant

as VIX futures move towards expiry while realized variance risk gradually decreases as

each day reveals a new term of the final variance.

This article focuses on the VPD and VPN. The VPD tracks the value of a portfolio that

overlays a sequence of short one-month VIX futures on a money market account. The

VIX futures are held until expiration and new VIX futures are then sold. The money

market account decreases leverage relative to a stand-alone short position in VIX futures.

To further decrease the risk of being short implied volatility, the number of VIX futures

sold at each roll is set to preserve 75% of the initial value of the portfolio in the event that

VIX futures increase by 25 points1.

The decision to target the maximum loss resulting from a 25 point increase in VIX futures is based on the

historical frequency distribution of one-month changes in implied volatility, as proxied by VXO, the old

VIX. Over any one-month period between January 1986 and July 2007, VXO has increased by more than

25 points 0.34% of the time, and 0.037% if we omit the fall of 1987.

CBOE Proprietary Information

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

Similar to the VPD, the VPN sells monthly VIX futures over a money market account. In

addition, it limits the risk of the short VIX exposure with long VIX calls struck 25 points

higher than the VIX futures price, or at the closest strike below when this strike is not

listed. Since the multiplier of VIX options is 100, each VIX futures is covered by 10

VIX calls.

Construction of CBOE VIX Premium Strategy Index

The VPD represents the value of an initial investment of $100 in a portfolio that

passively follows the VIX Premium Index Strategy. The portfolio is managed and

calculated as follows:

At the close of June 15, 2004, the inception date, $100 is invested at the three-month

Treasury bill rate2. On June 16, 2004, the first roll date, VIX futures are sold at the

opening bid price of VIX futures. From thereon, the futures are marked-to-market

daily at the close and the resulting cash flow is credited to or debited from the

opening money market balance.

At the next expiration, July 14, 2004, the futures position is settled at the open to the

final settlement price, new VIX futures are sold at the opening bid price. The cash

flows from the final mark of expiring contracts and from the daily closing marks of

the new contracts are financed from the money market balance.

Final Settlement Price of Expiring VIX Futures and Options

At expiration, VIX futures and options are settled to a Special Opening Quotation (SOQ)

of VIX. The SOQ is a special calculation of VIX compiled from the opening prices of

S&P 500 Index (SPXSM) options.

Calculation of VPD

CBOE currently calculates the VPD once per day at the close of trading. On any given

date, the index represents the mark-to-market value of the initial $100 invested in the

VIX Premium Index Strategy.

At the close of every business date, the value of the VIX Premium Index is equal to the

value of the Treasury bill account, obtained by compounding the Treasury Bill balance at

2

The intra-day cash from settling futures at the open is deemed to be invested at the close of the roll date.

Similarly, settlement losses are deemed to be financed at the close.

3

During the first two years of VIX futures, new contracts expiring in the next month were not listed on

several occasions. The index was then calculated using a position in the second month.

CBOE Proprietary Information

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

the previous close by the Treasury rate and netting the cash flow from marking VIX

futures to market:

VPDt = M t = (1 + rt 1 )VPDt 1 1000 N last ( Ft Ft 1 )

where Mt is the Treasury bill balance at the close of date t, rt-1 is the effective Treasury bill

rate from date t-1 to date t, Nlast is the number of futures sold at the last roll date, Ft is the

daily settlement price of VIX futures t, and 1000 is the multiplier of VIX futures.

On a roll date, the cash flow from final settlement of the expiring futures and their daily

mark at the close are both netted from the money market balance:

VPDt = (1 + rt 1 )VPDt 1 1000( N last ( SOQt Ft 1 ) N new ( Ft Fbid ))

where SOQt is the final settlement price of the expiring VIX futures, Nnew is the number

of new VIX futures sold, and Fbid is the opening bid price of VIX futures. This balance is

reinvested at the daily Treasury rate until the next date.

The number of new VIX futures sold at the open on a roll date t is set such that a 25 point

increase of VIX futures at the next roll still preserves 75% of capital available after the

final settlement of VIX futures:

N new = M to (1 + Rt .75) /(1000 * 25)

where Mto is the amount in the money market account at the open after the final

settlement of VIX futures, and Rt is the effective three-month Treasury bill rate to the

next roll date.

M to = M t 1 1000 N last ( SOQt Ft 1 )

The VPN represents the value of an initial investment of $100 in a portfolio that

passively follows the Capped VIX Premium Index Strategy. The portfolio is managed

similarly to the uncapped portfolio. The difference is that one-month out-of-the-money

VIX calls are bought at the same time that VIX futures are sold:

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

At the close of June 15, 2004, the inception date, $100 is invested at the three-month

Treasury bill rate4. On June 16, 2004, the first roll date, VIX futures are sold at the

opening bid price of VIX futures and 10 times as many VIX calls are bought at a

strike price 25 points greater than the opening bid price of VIX futures. If this strike

price is not listed, the calls are bought at the closest strike below. From thereon, as

for the VPD, the futures are marked-to-market daily at the close and the resulting s

cash flow is credited to or debited from the money market balance.

At the next expiration, July 14, 2004, the futures and option positions are settled at

the open to the final settlement price, new VIX futures are sold at the opening bid

price and new VIX calls are bought at the opening ask price. The cash flows from the

final mark of expiring contracts and from the daily closing marks of the new futures

are financed from the money market balance.

Calculation of VPN

CBOE currently calculates the VPN once per day at the close of trading. On any given

date, the index represents the mark-to-market value of the initial $100 invested in the

Capped VIX Premium Index strategy.

At the close of every business date, the value of the VPN is equal to the closing value of

the Treasury bill account plus the mark-to-market value of the VIX calls:

where Mt is the Treasury bill balance at the close of date t, Nlast is the number of futures

sold and 10 Nlast is the number of VIX options bought at the last roll date, Ft is the daily

settlement price of VIX futures t, and Ct is the average of the bid and ask quotes of the

VIX calls at the close. The Treasury bill balance is obtained by compounding the

previous closing Treasury balance at the three-month Treasury bill rate and netting the

cash flow from the mark of VIX futures:

M t = (1 + rt 1 ) M t 1 1000 N last ( Ft Ft 1 )

M t 1 = VPN t 1 1000 N last C t 1

4

The intra-day cash from settling futures at the open is deemed to be invested at the close of the roll date.

Similarly, settlement losses are deemed to be financed at the close.

5

During the first two years of VIX futures, new contracts expiring in the next month were not listed on

several occasions. The index was then calculated using a position in the second month.

CBOE Proprietary Information

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

where rt-1 is the effective Treasury bill rate from date t-1 to date t.

At the close of a roll date, as on regular days, the index is equal to the closing Treasury

balance plus the mark of the new options. The closing Treasury balance is now equal to

the Treasury balance at the previous close compounded by the daily Treasury rate net of

the cash flows from (1) final settlements of VIX futures and options, (2) the daily mark of

new VIX futures and (3) the purchase of new VIX calls.

VPN t = (1 + rt 1 ) M t 1 + 1000 N last (max[0, SOQt K ] ( SOQt Ft 1 )) + 1000 N new (C t C a ( Ft Fbid ))

where SOQt is the final settlement price of the expiring VIX futures, K is the strike of

the expiring VIX calls, Nnew is the number of new VIX futures sold, Ca is the ask price of

the VIX calls bought at the open, Fbid is the opening bid price of VIX futures. As on nonroll dates, the Treasury balance is reinvested at the Treasury rate.

The number of new VIX futures sold on a roll date t is set such that a 25 point increase of

VIX futures at the next roll still preserves 75% of capital available after the final

settlement of the VIX futures and options:

N new = M to (1 + Rt .75) /(1000 * (25 + (1 + Rt )C ask )

M to = (1 + rt 1 ) M t 1 + 1000 N last (max[0, SOQt K ] ( SOQt Ft 1 ))

where Rt is the effective three-month Treasury bill rate to the next roll date.

Historical Performance

Chart 1 Indexes

VIX Premium

June 04 - October 07

175

165

155

VARB-X

S&P 500 Total Return

145

135

125

115

VPD105

8/30/2007

6/30/2007

4/30/2007

2/28/2007

12/30/2006

10/30/2006

8/30/2006

6/30/2006

4/30/2006

2/28/2006

12/30/2005

10/30/2005

8/30/2005

6/30/2005

4/30/2005

2/28/2005

12/30/2004

10/30/2004

8/30/2004

6/30/2004

95

From June 2004 to October 2007, the VPD increased by approximately 61%, earning an

annual geometric return of 15.17%. Over the same period, the S&P 500 Total Return

Index (SPTR) increased by approximately 43% and earned an annual geometric return of

CBOE Proprietary Information

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

11.08%. The pronounced skew of the VPD indicates that the Sharpe ratio, based on the

standard deviation of the return, is a misleading measure of risk-adjusted return. The

semi-Sharpe ratio based on the semi-deviation is preferable. The semi-standard deviation

of the VIX Premium Index was 5.31%, equal to the semi-deviation of the S&P 500 Total

Return Index. Adjusting its monthly rate of return by its semi-deviation, the VPD

performed better than the S&P 500 but not as well as VARB-X.

Chart 2

VIX Premium Index

Frequency Distribution of Monthly Returns

35%

30%

25%

20%

15%

10%

5%

0%

-5.00% -4.00% -3.00% -2.00% -1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

VIX Premium

VARB-X

25% loss at 25 VIX Premium

Monthly Returns 6/04-10/07 S&P 500

pt vol increase Capped

Minimum Return

-4.24%

-1.77%

-5.82%

-6.29%

Arithmetic Mean Monthly

0.91%

0.69%

1.21%

1.14%

Annualized Geometric Mean

11.08%

8.50%

15.17%

14.22%

Annualized Std. Deviation

Monthly Sharpe Ratio

Annualized Semi-Deviation

Monthly Semi-Sharpe Ratio

Skew

Excess

VPN Kurtosis

8.47%

0.24

5.31%

0.11

-0.32

-3.40

2.89%

0.44

1.74%

0.21

-0.94

-1.85

8.04%

0.38

5.31%

0.17

-0.87

-1.51

8.11%

0.35

5.29%

0.16

-0.98

-1.21

In Chart 1, the reason the VPN coincides with the VPD until March 2006 is thats when

VIX options were introduced. From March 2006 to October 2007, the VPN earned an

CBOE Proprietary Information

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

annual geometric return of 14.22%, compared to 15.17% for VPD and 11.08% for the

S&P500 Total Return Index. This smaller return will typically be the case because the

probability of exercising calls purchased 25 points out-of-the-money is very small. Its

semi standard deviation was comparable to that of the VPD as was it semi-Sharpe ratio.

VIX Premium

VARB-X

25% loss at 25 VIX Premium

Monthly Returns 3/06-10/07 S&P 500

pt vol increase Capped

Minimum Return

-3.10%

-1.77%

-5.82%

-6.29%

Arithmetic Mean Monthly

1.11%

0.61%

0.89%

0.75%

Annualized Geometric Mean

13.82%

7.55%

10.70%

8.84%

Annualized Std. Deviation

Monthly Sharpe Ratio

Annualized Semi-Deviation

Monthly Semi-Sharpe Ratio

Skew

Excess Kurtosis

8.47%

0.36

5.31%

0.15

-0.63

-3.28

2.89%

0.28

1.74%

0.17

-0.67

-3.18

8.04%

0.21

5.31%

0.11

-0.77

-1.93

8.11%

0.15

5.29%

0.08

-0.88

-1.70

Conclusion

The market demand for volatility hedges has made it profitable to sell volatility. While

selling realized volatility is a well-established strategy, the attractive if riskier alternative

of selling pure implied volatility is relatively recent as it could not be easily implemented

before VIX futures and options were introduced. The VIX Premium Strategy Index and

Capped VIX Premium Strategy Index codify short implied volatility strategies and give

investors useful benchmarks to gauge their performance.

CBOE, Chicago Board Options Exchange, CFE, CBOE Volatility Index and VIX are registered

trademarks, and SPXSM, BXMSM, VPDSM, VPNSM, VXVSM and VARB-XSM are servicemarks of Chicago

Board Options Exchange, Incorporated (CBOE). The methodologies of the CBOE volatility indexes and

variance derivatives are owned by CBOE and may be covered by one or more patents or pending patent

applications. Standard & Poor's, S&P, and S&P 500 are registered trademarks of The McGraw-Hill

Companies, Inc. and are licensed for use by CBOE. All other trademarks and servicemarks are the

property of their respective owners.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person

must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are

available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One

CBOE Proprietary Information

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

North Wacker Drive, Suite 500, Chicago, Illinois 60606. Past performance does not guarantee future

results. The information in this document is provided solely for educational and informational purposes.

Copyright (c) 2007, Chicago Board Options Exchange, Incorporated. All rights reserved.

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