Inside Volatility Trading: Not All Tenors Behave the Same

Kevin Davitt

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January 15, 2020

As the holiday season draws to a close, I am reminded of the music of my childhood. When we put up holiday decorations my mom would invariably play The Three Tenors Christmas on an antiquated cassette player. I can still hear Luciano Pavarotti, Plácido Domingo, and Jose Carreras singing Silent Night or Happy Christmas (War is Over) in my mind. They were the only “tenors” I knew until I started working on the Cboe.

In finance, tenor has a different meaning. Generally speaking, tenor is the time until maturity in the case of a loan, or time until expiration for derivatives. The tenor of any derivative contract is incredibly important.

Cboe led the industry forward yet again in 2005, by launching short-dated options (Weeklys℠) on the SPX℠ and OEX®. Weekly options became available on actively traded equity and ETF products in 2010. These products added new tenors for our end users and individuals and institutions liked the “sound” of it.

According to data from Trade Alert LLC, nearly 40% of OCC cleared options have a week and a half (10 days) or less until expiration. Roughly 60% of all options trading now has a maturity of 30 days or less. Clearly end users are finding tremendous utility in short-dated derivatives.

Source: TradeAlert

In 2015, Cboe introduced Weekly VIX futures and options that afford our clients “volatility exposure that more precisely tracks the performance of the VIX® Index” according to Goldman Sachs. Historically, the closer the VIX® futures are to expiration, the more closely they tend to track the VIX® Index. These products allow investors and traders to position much more precisely in the volatility market, which has clearly been embraced in the equity/ETF and index option markets.

The chart above illustrates a historical sensitivity of VIX® futures relative to changes in the VIX® Index and days until (futures) expiration. Our geometry wonk readers might refer to it as an asymptotic curve. Those with less fond memories of quantitative coursework need to understand that longer dated VIX® futures (3+ months until expiration) have a comparatively low sensitivity to changes in the VIX® Index. Based on this data, a futures contract with 33 days until expiration (DTE) has a 0.39 beta.

Hypothetical w/term structure in contango:

VIX® Index declines from 14.00 to 13.00 over the course of a single day. The VIX® futures with 33 DTE might fall from 15.05 to 14.66 (down 0.39) over the same session.

Based on the same historical data, compare that to a VIX® futures contract with 1 DTE (0.79 beta)

Hypothetical w/term structure in contango:

VIX® Index declines from 14.00 to 13.00 over the course of single day. The VIX® futures with 1 DTE might fall from 14.25 to 13.46 (down 0.79) over the same session.

Cliff Notes: VIX® futures with a shorter tenor are far more responsive to changes in the VIX® Index.

From a use case scenario, an end user is trying to capture potential VIX® futures roll down more frequently in a normal term structure environment:

Based on historical data, about 70% of the profitability on short VIX® futures positions have occurred in the last week (5 business days) of trading. In a similar vein, the rate of decay on options increases dramatically in the week prior to expiration. Short VIX® futures, like short weekly option positions, present unique potential opportunities as well as meaningful risks, which must be understood.

The flip side of that proverbial coin – tactical hedges with long volatility positions in Weekly VIX® futures (or options) would be more likely to benefit from a move higher in the VIX® Index.

If, for example, a trader owned the VIX® futures that expired on January 8 (VX01F20) following the headlines about the drone strike that killed Iran's General Suleimani, the contract moved fairly quickly from 13.60 to 16.50. By contrast, the standard January futures (expiring Jan. 22) moved from roughly 14.12 to 15.98.

Source: Cboe

16.50 – 13.60 = 2.90*1000 (contract multiplier) = $2900 change in value for Weekly VIX® future

Source: Cboe

15.98 – 14.12 = 1.86*1000 (contract multiplier) = $1860 change in value for Standard Jan VIX® future

It’s worth noting, that the Cboe Futures Exchange℠ (CFE®) has seen a pronounced improvement in market quality for weekly VIX futures and a concurrent pickup in VIX weekly futures volume. Simply put, the bid/ask spreads for the non-standard VIX futures have narrowed which has incentivized greater trading activity.

So, as the decorations come down and Mariah Carey’s “All I Want for Christmas Is You” is surpassed by Post Malone’s “Circles” on the Billboard Hot 100 list, attention will return to episodic geopolitical risks, earnings season, and the likely path for global central banks in the New Year.

For those interested in more precise exposure to the volatility market, click here to learn more about short-dated VIX futures and options.

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