- What is VolX?
- What is volatility trading?
- Why trade volatility?
- What are RealVol futures?
- Is it always necessary for RealVol futures to be actual futures contracts?
- Why use a cash index as the “underlying”?
- Why use futures as the “underlying”?
- Are RealVol futures risky?
Alternative Volatility Exposure
- I can get volatility exposure already with options, so why should I trade RealVol futures?
- I can buy a straddle, delta-hedge it, and get the “same” exposure as from RealVol futures, right?
- What is the difference between realized volatility and implied volatility?
- Is there a difference between trading RealVol futures, which are based on realized volatility, and instruments based on implied volatility?
- Suppose that both RealVol futures and instruments on implied are successful. Will they both be available on “all” markets?
- What is Inferred Volatility?
- Why not just trade OTC volatility swaps?
- Is there a relationship between successive monthly RealVol futures expirations?
- What about the new monthly 1VOLs that expire each week?
- I thought volatility was mean reverting. Now you are saying that it is autocorrelated. Aren’t these contradictory concepts?
- Is there an arbitrage between the three serial months and the quarterly?
- Since the sensitivity of the RealVol futures price to volatility decreases throughout the RealVol calculation period, there won’t be much of a reason to trade in the last few days before expiration, right?
- Will there be natural sellers of RealVol futures?
- Since RealVol futures measures movement, and since the market always moves, can’t I continually buy a RealVol futures and win?
- You mentioned the high volatility of the one-month contract. Is the three-month contract just as volatile?
- How well can RealVol futures reduce the risk of an options portfolio?
- To reduce the risk of an options book, can I put on a RealVol futures offset and leave it until expiration?
- Why is volatility hedging an options book with RealVol futures a dynamic process?
- Is there a way to reliably spread RealVol futures with the underlying futures?
- Would buying RealVol futures in equities enhance the Sharpe ratio of my portfolio?
- Who is the target market?
- It seems as if only options users would be interested in trading volatility. Is that true?
- But, are options traders the primary users?
- Would futures traders use RealVol futures?
- Why would hedge funds trade volatility?
- Would volatility funds use the product?
- Surely, this product is too sophisticated for retail investors, right?
- Why would a corporation use RealVol futures?
The RealVol Daily Formula and Calculation
- The VolX formula has no mention of a mean. Why?
- Why do you use the log returns?
- The VolX formula always uses 252 trading days. Why?
- I have spot exposure. Will the RealVol futures use the spot price for their calculations?
- How is volatility captured by taking only one reference value per day?
- Is the contract size small?
- Is the performance bond high in the one-month contract?
- Why do RealVol futures settle to cash?
The VolX Indices and VolX Stats
- Does VolX settle the various RealVol futures to the published indices?
- Why does VolX publish nine indices for each asset?
- Will you publish the realized volatility, within the RealVol calculation period, as it accrues to the RealVol futures?
- Will you publish the GARCH forecast volatility for a specific RealVol futures’ expiration value?
- When will the 12-month contract be rolled out?
- Can this concept work for other assets?
- Will you ever roll out options, ETFs, and ETNs on realized volatility?
What is VolX?
The Volatility Exchange (VolX) aspires to be an exchange dedicated to trading realized volatility on a wide variety of assets. Market participants can trade the volatility, or movement, of an underlying asset or instrument regardless of direction. VolX has developed patented, standardized financial futures based on the daily realized volatility of underlying assets.
What is volatility trading?
Volatility trading allows a market participant to trade movement regardless of direction. RealVol futures are the first exchange-traded instruments that allow traders to trade risk, expressed as realized volatility, directly. Investors have always been able to measure risk, but never before could they speculate upon or hedge that risk directly.
Why trade volatility?
In our view, trading volatility is more flexible than trading direction with the underlying. With volatility trading, one can take a view on a future event and potentially make a profit regardless of which way that event turns out. Investing in volatility can help diversify away risk. It can also help manage the risk of an options book. RealVol futures may be able to increase the Sharpe ratio of an investor’s portfolio. Risk managers could use RealVol futures to make their risk models more robust. In short, there are dozens of uses for RealVol futures, including some that are not readily apparent.
What are RealVol futures?
Futures-like financial instruments that capture the daily realized volatility of an underlying asset, index, or instrument. The 1-month RealVol futures (1VOL), 3-month RealVol futures (3VOL), and 12-month RealVol futures (12VOL) allow market participants to hedge against, invest in, or speculate on, realized volatility on a short-term (about one month), intermediate-term (about three months), or even long-term (one year) basis.
Is it always necessary for RealVol futures to be actual futures contracts?
The futures industry is a perfect “home” for these instruments. RealVol futures were designed to function just like a typical futures contract so that market participants would be very familiar with the infrastructure and processes, and would most likely already have an established account to trade.
Why use a cash index as the “underlying”?
Using the cash index, or spot, for the reference prices is simple, accurate, and transparent. However, we aren't limited to using spot as the underlying, and could use various other assets, such as futures, securities, or instruments.
Why use futures as the “underlying”?
Using futures for the reference prices is also simple, accurate, and transparent. In many cases there isn't one "spot" price, but many. In such a case, which one should we use? Using a specific futures contract avoids all these issues.
Are RealVol futures risky?
One of the measures of risk is volatility. Since we are trading an instrument that is volatility itself, we now need to know how risky that instrument is. In essence, we need to determine the volatility of volatility (vol of vol). For many assets, the volatility for the three-month RealVol futures (3VOL) typically averages in the range of 30–35%, while the volatility in the one-month RealVol futures (1VOL) can often exceed 80% on an annualized basis (for many assets). In short, the realized volatility of RealVol futures may offer both trading opportunities as well as risks that need to be managed.
Alternative Volatility Exposure
I can get volatility exposure already with options, so why should I trade RealVol futures?
Options provide exposure to volatility and direction in one instrument. RealVol futures provide exposure solely to volatility, and allow participants to buy or sell volatility without the complexity of managing options positions.
I can buy a straddle, delta-hedge it, and get the “same” exposure as from RealVol futures, right?
Almost. A delta-hedged straddle strategy does give the holder volatility exposure. However, it is a costly and time-intensive process because follow-up transactions are required continually. Also, as the market moves away from the options’ strike, the overall position becomes less sensitive to volatility. Many call that “path dependency.” RealVol futures do not have path dependency and, as a result, provide pure daily realized volatility exposure.
What is the difference between realized volatility and implied volatility?
Implied volatility is the relative expensiveness of an option. Theoretically, it is the market’s guess of future risk. Realized volatility is the risk itself. Trading the actual risk as opposed to the price level of options premiums are two very different endeavors. For example, if you were an insurance company selling life insurance, you have two risks: the risk that the yearly revenue from premiums would fall (reducing your future cash flows), and the risk of the insured’s dying. Instruments on implied volatility can only hedge the cash flows. RealVol futures can hedge the cash flows and the actual risk.
Is there a difference between trading RealVol futures, which are based on realized volatility, and instruments based on implied volatility?
RealVol futures give the market participant exposure to both implied-like pricing and realized pricing all in one instrument. In other words, the contracts have perception of the future risk and the reality of actual risk embedded within their structure. Instruments on implied volatility can only address the perception of risk – and they can capture that only through options pricing.
Suppose that both RealVol futures and instruments on implied are successful. Will they both be available on “all” markets?
No. Instruments on implied volatility must have an options market in order to calculate the underlying index value. And, the options must have a liquid market for reasonable pricing. Unfortunately, this limits implied volatility products to only a handful of the largest, most liquid, options markets in the world. RealVol futures can be priced on any underlying with a daily closing, or settlement, price. RealVol futures can list on hundreds, perhaps thousands, of underlying futures, assets, indices, stocks, and ETFs. Instruments on implied cannot.
What is Inferred Volatility?
IVOL stat (inferred volatility stat) uses the PVOL stat (partial realized volatility stat) value of the RealVol futures and the current market price to infer the remaining realized volatility forecast until expiration. In a manner of speaking, inferred volatility is similar in concept to implied volatility. Implied volatility is derived from option prices while inferred volatility is derived from RealVol futures prices.
Why not just trade OTC volatility swaps?
Volatility swaps are very similar to RealVol futures. They are both based on realized volatility, and the two formulas share many similarities. However, volatility swaps have counterparty risk, pricing is not transparent, typically the ticket size needs to be large, and there are also legal considerations. In short, many market participants are unwilling or unable to trade volatility swaps.
Is there a relationship between successive monthly RealVol futures expirations?
Not necessarily. Taken as discrete 21-day periods, January volatility is distinct from February volatility, which, in turn, is distinct from March volatility. There is virtually no overlap, except for perhaps a day or so. However, that said, volatility has been shown to be autocorrelated. This means that high volatility often begets high volatility, and low begets low. Another way to say this is that volatility often persists, or clusters. Therefore, if January were highly volatile, then February would most likely display higher-than-average volatility as well.
What about the new monthly 1VOLs that expire each week?
Here, of necessity, there will be some overlapping of the data points, and this will affect the relationship between successive contracts that expire from one week to the next. If a 1VOL expires on, say, the 10th of the month, and the next one expires on the 17th, it is logical to assume that the two will share many of the same data points and, therefore, may display similar volatilities. Of course, that said, as old points drop out, to be replaced by new ones, the contract settlement values, while potentially similar, can and will be expected to differ.
I thought volatility was mean reverting. Now you are saying that it is autocorrelated. Aren’t these contradictory concepts?
On the surface, it might seem so. Autocorrelation means that volatility persists. Mean reversion means that high values tend to move lower (toward the average) and low values tend to move higher (toward the average). One can think of both phenomena as coexisting in this manner: Suppose that the average yearly temperature for a city is 55 degrees. It is now August, and we are in the midst of a heat wave, with several consecutive days of over-90-degree temperatures. If we were to try to predict the temperature for, say, next week, we would hardly forecast 55, as it would be highly likely that the warm weather would persist for a while longer. However, eventually, the seasons change, autumn arrives, and with it, comes a return to cooler readings. As with temperature, severe levels of volatility might cluster, or persist, for some time, but, eventually, they always return, or revert, to the mean.
Is there an arbitrage between the three serial months and the quarterly?
Not quite. Executing three 1VOLs, say, in April, May, and June, and spreading those contracts against the 3VOL for Q2, would give close to the same final value(s). However, they would not usually be identical. Volatility is a curve function. One cannot simply add three monthly curves to get one aggregate quarterly curve. In short, serial volatilities are not additive. In addition, because of the vagaries of the calendar, three 21-trading-day 1VOLs may not coincide exactly with a particular 63-trading-day 3VOL. For example, if the third Friday of each month is expiration day, 21-trading-days prior to expiration from any one particular expiration day may not coincide exactly with the previous month's third Friday expiration day. In fact, 21 trading days cannot coincide with expirations because the third Friday each month is either four weeks (20 trading days) or five weeks (25 trading days) away. This means that there will either be overlapped or missing days when comparing the corresponding three 1VOLs to a continuous 63-day 3VOL contract.
Since the sensitivity of the RealVol futures price to volatility decreases throughout the RealVol calculation period, there won’t be much of a reason to trade in the last few days before expiration, right?
While the price sensitivity to underlying volatility will decrease throughout the RealVol calculation period, RealVol futures could be considerably volatile right to expiration. For example, suppose that trading in a 1VOL is nearing its expiration such that there is one day left of a 21-day Realized-Volatility Period. For the first 20 days, the market moved exactly 1% each day. And, for argument’s sake, let’s assume that the market was anticipating 1% movement for the last day as well. In that case, at the close today (the next-to-last day), the market might trade the RealVol futures at approximately 16.00. However, unexpected news comes out on the last day and the market moves 4%. In this case, the contract would settle at 20.78, for a gain of almost 30% on the last day. The bottom line is that large moves in RealVol futures are possible right to expiration. This highlights the considerable opportunity for traders but also the substantial risk for hedgers that needs to be managed.
Will there be natural sellers of RealVol futures?
It is expected that there will be a risk premium embedded within the RealVol futures such that a seller could gain a small amount daily for accepting theoretically unlimited risk. Therefore, yes, we expect a vibrant market on both sides.
Since a RealVol futures measures movement, and since the market always moves, can’t I continually buy a RealVol futures and win?
RealVol futures will be priced near to where market participants in aggregate will forecast the expiration value, plus a risk premium. Therefore, profits can accrue to buyers or sellers depending on the resulting value of the contract and whether it moves higher or lower.
You mentioned the high volatility of the one-month contract. Is the three-month contract just as volatile?
No. Because the calculation of expiration volatility includes many more days, the resulting volatility of the 3VOL is typically about one-half to two-thirds less volatile.
How well can RealVol futures reduce the risk of an options portfolio?
RealVol futures should do an excellent job of hedging the risk of an options portfolio. Simulations performed at VolX have shown a risk reduction similar to that of delta hedging. In options terms, delta hedging reduces the directional risk while RealVol futures can mitigate both the vega (implied volatility) and gamma (directional movement) risks.
To reduce the risk of an options book, can I put on a RealVol futures offset and leave it until expiration?
Our research indicates that adding a static RealVol futures offset to a delta-hedged options portfolio will substantially reduce the volatility risk of the portfolio. However, for the best possible risk reduction, the RealVol futures offset requires a dynamic process similar to delta hedging.
Why is volatility hedging an options book with RealVol futures a dynamic process?
The sensitivity of the RealVol futures to changes in volatility is reduced as expiration draws nearer. Also, the gamma of an options book could be increasing or decreasing as expiration approaches depending on the strike prices of the options. Therefore, the sensitivity of the RealVol futures to the vega and the gamma sensitivities of a particular options book varies continually and needs to be adjusted periodically for the best hedging outcome.
Is there a way to reliably spread RealVol futures with the underlying futures?
Yes, there are two potential ways:
- First, if there is a correlation between volatility and the direction of the underlying. For example, historically, as the equity market falls, volatility increases, and vice versa. We call this a strong negative correlation (markets fall and volatility rises; markets rise and volatility falls). In some commodities there is a strong positive correlation (markets rise and volatility rises; markets fall and volatility falls). In some assets, like currencies, there is little correlation between price movement and volatility. Currencies would not be a good candidate for spreading futures with RealVol futures, as reliably repeatable results would be unlikely over periods of time.
- Another spread opportunity is the strong directional relationship embedded within RealVol futures within the trading day. Suppose that the market rises 2% and then falls 2% all within the same day. What happens to RealVol futures within the RealVol calculation period? For that one day, they have a volatility of zero because RealVol futures measure only the close-to-close change. Savvy traders may be able to fashion a real-time spread between RealVol futures and futures that takes advantage of this embedded directionality of RealVol futures.
Would buying a RealVol futures in equities enhance the Sharpe ratio of my portfolio?
There have been numerous studies on this subject and they all seem to point to the ability for enhanced portfolio performance (increased Sharpe ratio) by the addition of volatility hedges to a well-diversified equity portfolio. We would expect the performance of RealVol futures to be a favorable addition to the portfolio as well. However, RealVol futures are not yet available on any equity index. Therefore, the benefits of adding a long RealVol futures position to a portfolio of stocks have not been demonstrated empirically.
Who is the target market?
Senior officers of VolX have visited hundreds of firms in countries around the globe. The enthusiasm for the products has been overwhelming from every type of market participant. We have met with investment banks, futures market-makers, options market-makers, CFD houses, interdealer brokers, OTC platforms, FCMs, speculators, high-frequency trading shops, day-traders, hedge funds, pension funds, etc.
It seems as if only options users would be interested in trading volatility. Is that true?
Quite the contrary. Nearly every type of market participant has a fundamental need to manage risk. RealVol futures are the first listed product capable of managing risk, defined as realized volatility, directly.
But, are options traders the primary users?
We expect that many options traders will use RealVol futures to make markets formally or informally in RealVol futures. In addition, they can use RealVol futures to manage their volatility exposure. One of the reasons that options traders would use the product more readily is that they already well understand the concept of volatility.
Would futures traders use RealVol futures?
RealVol futures are futures contracts. Futures traders are very familiar with the product. Exchanges, clearinghouses, clearing firms, FCMs, and software vendors would be comfortable listing the product simply as just another futures instrument.
Why would hedge funds trade volatility?
One of the primary mandates of the hedge fund industry is to provide investors with non-correlated returns to general economic conditions. Toward that goal, many are coming to see the unique pattern of returns available by trading in volatility. Adding a small portion of assets to volatility-based strategies often reduces risk with the objective of increasing the Sharpe ratio of the overall portfolio.
Would volatility funds use the product?
Absolutely. There is a subset of hedge funds and managed futures programs where the primary “asset” of choice is volatility. This fairly new and innovative segment of the fund industry is clamoring for the launch of RealVol futures on various assets.
Surely, this product is too sophisticated for retail investors, right?
Not at all. The formula is simple. The essence of the concept is even simpler. Think of RealVol futures as just trading the movement of some underlying asset without regard to direction. Another way to think of the idea is that it allows a trader to speculate on just the magnitude of importance of a future event, without needing to specify which way the event will actually turn out, in order to profit from the trade.
Why would a corporation use RealVol futures?
Many corporate users have risk groups that are measuring their interest-rate risk, foreign-currency risks, and raw-materials risk. And, all of these risk groups use models that are, for the most part, based on volatility. Unfortunately, one of the assumptions with all of these risk models is that future volatility remains constant. As we have shown above, volatility is one of the most volatile of all assets. The constant-volatility assumption is not valid. However, if one could trade volatility, hedge the volatility risk, and make it a near constant, then all the aforementioned risk models could become more robust. RealVol futures might be just the tool most needed by corporate users to manage their various risks more effectively.
The RealVol Daily Formula and Calculation
The RealVol daily formula has no mention of a mean. Why?
Having a mean works well for taking an exit poll or trying to determine the height of children in fifth grade, but it does not work well for markets. Subtracting the mean would be removing the trend. Also, setting the mean to zero provides an instrument for options hedgers that more closely aligns RealVol futures with the risk inherent within an options portfolio.
Why do you use the log returns?
Calculating the log is the way to get continuously compounded returns.
The RealVol daily formula always uses 252 trading days. Why?
We need an annualization factor. It is better to specify one constant value than to have a potentially confusing array of many exact, but different, values for markets worldwide.
I have spot exposure. Will the RealVol futures use the spot price for their calculations??
In many instances, yes. It is our plan to use the underlying cash index as the basis for calculating the volatility of NASDAQ-100 RealVol futures. However, the difference between spot volatility and futures volatility should be negligible. Thus, if one has volatility risk and needs to hedge that risk, it might also be practical, for other underlyings, to settle the VolContract futures to the volatility of futures prices as the basis for the settlement calculation.
How is volatility captured by taking only one reference value per day?
This is the most widely used method of calculating volatility. Not only is it an accepted standard, it has also been shown to be a fairly accurate measure of the volatility over a time period of at least one month.
Is the contract size small?
If the volatility were, say, 15%, this would be quoted as 15.00 (without the percentage sign). And, the notional contract size would be $1,000 times the price, or $15,000 in this case. Typical futures markets have contract sizes in the $50,000 to $100,000 range, and sometimes much higher, especially in interest-rate products. On the surface, it seems like it would take a lot of RealVol futures to acquire a reasonably large position, but the very high volatility of volatility means that even a small contract size could provide considerable price action and profit opportunities.
Is the performance bond high in the one-month contract?
1VOLs can be highly volatile instruments. The performance bond is commensurate with the opportunity and the potential risks. However, since the 3VOL contract is much less volatile, its performance bond is commensurate with that lower risk. In fact, at times, RealVol futures could move more on a dollar-for-dollar basis than the underlying futures even though the notional size of the underlying futures contract is typically much larger.
Why do RealVol futures settle to cash?
There is no “physical” underlying a RealVol futures, as it settles to a mathematical calculation. In other words, there is no “spot” or “cash” market in volatility to settle to. Therefore, there is no possibility of delivery.
The RealVol Indices and RealVol Stats
Does VolX settle the various RealVol futures to the published indices?
Yes. Indices are rolling sets of trading days. For example, the daily 1-month realized volatility index (1RVOL) comprises 21 trading days of returns rolling through time in a continuous process. The 3-month index (3RVOL) uses 63 trading days. Initially, these two RealVol indices and, perhaps later, the one-year version (252 trading days), will be used to settle all RealVol futures.
Why does VolX publish nine indices for each asset?
In addition to the aforementioned RVOL Indices, VolX publishes indices of the realized volatility of realized volatility (RVOV) and, courtesy of The Volatility Institute, also publishes forecasts of future realized volatility (FVOL). As each of these three indices will have three time references (one month, three months, and, eventually, one year), there are nine indices in all.
Will you publish the Realized Volatility, within the RealVol calculation period, as it accrues to the RealVol futures?
Yes. We call this calculation the Partial Vol (PVOL) stats. It will be available daily on the web site.
Will you publish the GARCH forecast volatility for specific RealVol futures' expiration value?
Yes. We call this calculation the GARCH Vol (GVOL) Series. It too will be available daily on the web site.
When will the 12-month contract be rolled out?
This depends on market demand and market-maker acceptance. Such a long-term contract would be most useful to long-term options market-makers and hedge funds that want to invest in volatility. The volatility of the 12VOL (RealVol of Vol) ) is expected to be very low, almost bond-like.
Can this concept work for other assets?
Absolutely. We plan to roll out RealVol futures on all of the major asset classes in time: currencies, interest rates, equity indices, energy, metals, and commodities. Our first offering was with the CME on their FX products.
Will you ever roll out options, ETFs, and ETNs on realized volatility?
Yes, we expect to do so. RealVol options, RealVol ETF, RealVol ETNs will be launched as soon as possible after RealVol futures trade.
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