The VIX Index And A Brief History Of Volatility Trading

With so much interest in VIX linked Exchange Traded Products (ETPs) like VXX, XIV, and SVXY, etc., I thought it might be worth putting some of these products into context, and explain why their growth might have less to do with volatility trading and more to do with a unique facet of the VIX index.

By way of background, I have made my career as a volatility trader. In 2000 I joined a large investment bank in London, trading what was then one of Europe’s largest volatility trading books. I later established a similar business for that bank in New York, and soon became one of the largest options and variance swap market makers in the US. That business grew rapidly and went on to launch the first volatility ETP – the VXX. Since then I have helped launch several more VIX ETPs and now manage volatility portfolios for individuals, institutions, and other advisors.

Over the years the market for VIX ETPs has grown tremendously, and daily volumes of the most popular products sometimes exceed $1BN each.  This impressive volume has drawn so much media focus that it is sometimes easy to forget that VIX ETPs fit into the broader volatility market.  To help remind us, it may be useful to discuss what volatility trading is, and how it came about in the first place.

Volatility, in the financial sense, describes the movement of an instrument’s price rather than the actual price itself. Any instrument whose price moves exhibits price volatility and volatility trading is trading the expected future volatility of that price. Volatility traders are therefore less interested in whether a price goes up or down, and more interested in how much and how frequently the price might move.

The first, and still most popular, way to trade volatility is to trade options. The price of an option is determined by several factors including expected future volatility – usually called implied volatility. If all of the pricing factors excluding implied volatility are hedged, the trader can be left with a naked implied volatility position, and as implied volatility rises, the price of the option rises. This volatility/price relationship is referred to as Vega.

Stock options have been actively traded on organized exchanges in the US since 1973, greatly aided by the pricing methodology presented by Fischer Black and Myron Scholes in their article ‘The Pricing of Options and Corporate Liabilities’.[1] In essence, Black and Scholes catalyzed the options market by demonstrating how an option could be priced as a function of interest rates, dividends, stock price, and implied volatility – ultimately offering us the opportunity of trading implied volatility.

I won’t delve further into options pricing here, but if you are interested in reading more, two of the most important books on the subject are John Hull’s ‘Options, Futures, and other Derivatives’ and Sheldon Natenberg’s book ‘Option Volatility and Pricing’.[2] I’ve put a more complete reference in the footnote.

In addition to stock options, index options have seen tremendous growth over the last 30 years. In 1983 the CBOE launched the S&P 100 index (Ticker: OEX) specifically to facilitate index options trading, and at the same time listed options on the existing S&P 500 Index (Ticker: SPX).[3] For many years options on the OEX were far more liquid than the SPX, and as we’ll see later, it was the OEX that the VIX Index first referenced.