Investing in Fear Is Big Business
by Brendan Conway
Call it a bull market in fear.
The popularity of the VIX index, which has become a widely watched barometer of investor fear since the financial crisis, is generating a host of spinoffs, copycats and derivatives. It is adding up to big business for VIX's owner, the Chicago Board Options Exchange, as well as partners and competitors that have developed products pegged to, or inspired by, the VIX.
VIX clones have sprung up in Australia, Canada and India. There are now VIX-like measures in the crude-oil and gold markets. Soon, there will be a VIX each for corn and soybeans. The popularity of the index has fueled growth in futures and options just to bet on the VIX itself.
Formally known as the CBOE Market Volatility Index, the VIX tracks the prices investors pay for options to protect themselves against swings in the Standard & Poor's 500-stock index. An increase in those prices suggests an increase in investor anxiety. It is also used as a short-term predictor of investor behavior.
"There's not a bubble in volatility—investors can expect more of that—but there's certainly one in products to trade it," said Michael McCarty, managing partner of Austin, Texas-based Differential Research. Mr. McCarty and others in the industry predict that not all the new offerings will survive. Interest in fear gauges seems likely to wane once markets settle, they say.
The CBOE is the main beneficiary of the boom as it collects licensing and transaction fees on most VIX-related products. The CBOE and its partners are tight-lipped about the terms of the deals, but Ticonderoga Securities analyst Chris Allen estimates the VIX is now worth at least $300 million to the exchange. That is about one-eighth the company's entire market capitalization.
"The VIX is one of the fastest-growing products in the history of the business," CBOE Chairman William Brodsky said in an interview.
The VIX has become such big business that the CBOE expanded the pit that houses trading in VIX products at a time when volume in the industry has been largely flat. The pit was built to be deliberately roomy so it could accommodate an expected explosion in VIX-related trading. The pit has plenty of empty posts, contrasting with the crowded nearby pit for trading S&P 500 options.
Trading volume in VIX options alone rose 42% in the third quarter from a year earlier, according to the CBOE. VIX options worth more than a notional $120 billion have traded on the exchange this year, according to CBOE figures.
Every time one of these options on the VIX trades, the CBOE collects a fee, making it the most promising money maker for the exchange. The fees added up to $6.4 million in the third quarter, which if replicated again, could see the exchange reap at least $25 million this year.
Other firms and exchanges are also seeking to capitalize on the VIX's popularity.
Over at CME Group Inc. (NASDAQ: CME - News), a whole separate group of traders is trading futures on the VIX. Investment banks such as Citigroup Inc. (NYSE: C - News), Barclays PLC (NYSE: BCS - News) and Credit Suisse Group are using the VIX to create complex new exchange-traded notes tied to the index. The Nasdaq OMX Group (NASDAQ: NDAQ - News) recently launched competing "Alpha Indexes."
Some worry that the broad array of products and growth in trading of VIX options and futures could attract investors who don't fully understand the risks. The options can swing wildly in price as sentiment shifts, and investors could easily be caught off guard.
Even having a barometer of fear can make it easier for that fear to spread. That was brought into stark relief during the financial crisis through the ABX indexes, rough measures of mortgage-backed debt prices, and credit-default swaps, which reflect sentiment on individual borrowers. Both have been demonized as products that only compound investor nervousness.
"Derivatives themselves are a good product, but using them without being educated on how they work will eventually lead to big trouble," said Joe Kinahan, TD Ameritrade chief derivatives strategist. For example, he said, VIX options have an inverse relationship to the market, something that has tripped up unsuspecting investors.
For example, investors who had bet against stock-market volatility in April after a strong run in the stock market would have lost money in the May 6 "flash crash," which saw the VIX spike. But less volatile environments can also cause traders to lose money. For instance, investors who bet on a rocky fall for stocks by buying VIX "call" options saw their investments' value mostly bleed away, especially after the midterm elections and the Federal Reserve's quantitative-easing news.
Headaches for the CBOE have also been created by unwelcome copycats.
Last year, California investment firm AlphaShares LLC launched the AlphaShares Chinese Volatility Index, or "CHIX." It tracks gyrations in the Chinese market but isn't licensed by the CBOE.
CHIX has caused a spat between the CBOE and AlphaShares, with CBOE asking AlphaShares to tone down its references to the VIX. CBOE declined to comment. AlphaShares, of Walnut Creek, Calif., describes the China index as a "tribute" to the VIX.
The VIX was born when the CBOE commissioned Robert Whaley, then a professor at Duke University, to design a market-volatility index. He presented the math equation that would become the VIX in a 1993 academic paper. VIX futures became tradable in 2004, followed by VIX options in 2006, enabling investors to bet on the direction of the VIX.
For his part, Prof. Whaley says he wondered what took the market so long to see the benefits of being able to hedge against, or bet on, volatility in the stock market.
"Their current trading volume figures say they now understand," said Prof. Whaley, who is now at Vanderbilt University's Owen Graduate School of Management.
It wasn't until the financial crisis that the VIX broke into the mainstream. The index has a tendency to shoot up dramatically when market sentiment sours, one reason it grabbed so much attention as markets began imploding.
Within a few weeks in late 2008, the VIX shot up from the 20s to a peak of about 96 in October. Its reading is now just above 20, close to the historical average.
—Geoffrey Rogow contributed to this article.
Write to Brendan Conway at brendan.conway@dowjones.com
Call it a bull market in fear.
The popularity of the VIX index, which has become a widely watched barometer of investor fear since the financial crisis, is generating a host of spinoffs, copycats and derivatives. It is adding up to big business for VIX's owner, the Chicago Board Options Exchange, as well as partners and competitors that have developed products pegged to, or inspired by, the VIX.
VIX clones have sprung up in Australia, Canada and India. There are now VIX-like measures in the crude-oil and gold markets. Soon, there will be a VIX each for corn and soybeans. The popularity of the index has fueled growth in futures and options just to bet on the VIX itself.
Formally known as the CBOE Market Volatility Index, the VIX tracks the prices investors pay for options to protect themselves against swings in the Standard & Poor's 500-stock index. An increase in those prices suggests an increase in investor anxiety. It is also used as a short-term predictor of investor behavior.
"There's not a bubble in volatility—investors can expect more of that—but there's certainly one in products to trade it," said Michael McCarty, managing partner of Austin, Texas-based Differential Research. Mr. McCarty and others in the industry predict that not all the new offerings will survive. Interest in fear gauges seems likely to wane once markets settle, they say.
The CBOE is the main beneficiary of the boom as it collects licensing and transaction fees on most VIX-related products. The CBOE and its partners are tight-lipped about the terms of the deals, but Ticonderoga Securities analyst Chris Allen estimates the VIX is now worth at least $300 million to the exchange. That is about one-eighth the company's entire market capitalization.
"The VIX is one of the fastest-growing products in the history of the business," CBOE Chairman William Brodsky said in an interview.
The VIX has become such big business that the CBOE expanded the pit that houses trading in VIX products at a time when volume in the industry has been largely flat. The pit was built to be deliberately roomy so it could accommodate an expected explosion in VIX-related trading. The pit has plenty of empty posts, contrasting with the crowded nearby pit for trading S&P 500 options.
Trading volume in VIX options alone rose 42% in the third quarter from a year earlier, according to the CBOE. VIX options worth more than a notional $120 billion have traded on the exchange this year, according to CBOE figures.
Every time one of these options on the VIX trades, the CBOE collects a fee, making it the most promising money maker for the exchange. The fees added up to $6.4 million in the third quarter, which if replicated again, could see the exchange reap at least $25 million this year.
Other firms and exchanges are also seeking to capitalize on the VIX's popularity.
Over at CME Group Inc. (NASDAQ: CME - News), a whole separate group of traders is trading futures on the VIX. Investment banks such as Citigroup Inc. (NYSE: C - News), Barclays PLC (NYSE: BCS - News) and Credit Suisse Group are using the VIX to create complex new exchange-traded notes tied to the index. The Nasdaq OMX Group (NASDAQ: NDAQ - News) recently launched competing "Alpha Indexes."
Some worry that the broad array of products and growth in trading of VIX options and futures could attract investors who don't fully understand the risks. The options can swing wildly in price as sentiment shifts, and investors could easily be caught off guard.
Even having a barometer of fear can make it easier for that fear to spread. That was brought into stark relief during the financial crisis through the ABX indexes, rough measures of mortgage-backed debt prices, and credit-default swaps, which reflect sentiment on individual borrowers. Both have been demonized as products that only compound investor nervousness.
"Derivatives themselves are a good product, but using them without being educated on how they work will eventually lead to big trouble," said Joe Kinahan, TD Ameritrade chief derivatives strategist. For example, he said, VIX options have an inverse relationship to the market, something that has tripped up unsuspecting investors.
For example, investors who had bet against stock-market volatility in April after a strong run in the stock market would have lost money in the May 6 "flash crash," which saw the VIX spike. But less volatile environments can also cause traders to lose money. For instance, investors who bet on a rocky fall for stocks by buying VIX "call" options saw their investments' value mostly bleed away, especially after the midterm elections and the Federal Reserve's quantitative-easing news.
Headaches for the CBOE have also been created by unwelcome copycats.
Last year, California investment firm AlphaShares LLC launched the AlphaShares Chinese Volatility Index, or "CHIX." It tracks gyrations in the Chinese market but isn't licensed by the CBOE.
CHIX has caused a spat between the CBOE and AlphaShares, with CBOE asking AlphaShares to tone down its references to the VIX. CBOE declined to comment. AlphaShares, of Walnut Creek, Calif., describes the China index as a "tribute" to the VIX.
The VIX was born when the CBOE commissioned Robert Whaley, then a professor at Duke University, to design a market-volatility index. He presented the math equation that would become the VIX in a 1993 academic paper. VIX futures became tradable in 2004, followed by VIX options in 2006, enabling investors to bet on the direction of the VIX.
For his part, Prof. Whaley says he wondered what took the market so long to see the benefits of being able to hedge against, or bet on, volatility in the stock market.
"Their current trading volume figures say they now understand," said Prof. Whaley, who is now at Vanderbilt University's Owen Graduate School of Management.
It wasn't until the financial crisis that the VIX broke into the mainstream. The index has a tendency to shoot up dramatically when market sentiment sours, one reason it grabbed so much attention as markets began imploding.
Within a few weeks in late 2008, the VIX shot up from the 20s to a peak of about 96 in October. Its reading is now just above 20, close to the historical average.
—Geoffrey Rogow contributed to this article.
Write to Brendan Conway at brendan.conway@dowjones.com
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