trader Michael J. Zerinskas when the markets continually go into

The Anatomy of Volatility Futures (VXX, VIX)
Michael J. Zerinskas - Chief Options Strategist at Benzinga, provided by


SFGate November 26, 2010 04:00 AM Copyright SFGate. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.
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With Euro-fears, mixed macroeconomics data, and Korean skirmishes grabbing headlines, it is easy to get overly bearish on the movement of stock prices-this is a "natural" protective instinct. Those of us that trade for a living, however, cannot easily back away from the markets; we need to continually evaluate the landscape, monitor investor sentiment, and (most importantly) watch and interpret price action.

For me, when the markets continually go into a tizzy over the same recurring news, I turn to the volatility markets to see: 1.) what large, institutional traders are specifically expecting and/or hedging against, and 2.) what the futures markets are saying.

Given that the CBOE Volatility index (CBOE: VIX) is used primarily as a hedging vehicle, single trades of large size should be noted, though not in a directional fashion. This means that, if a large block of VIX $40 calls are bought, it does not inherently mean the trade voices the opinion that the VIX will rise to 40; it more often than not indicates a worry, which the trader is hedging against.

While you can look at individual trades in isolation, market theory illustrates that a large pool of data will give you the best reading of expectations. This is what the futures markets are for. The VIX futures will tell the story of what a large pool of large traders are worried about, so to speak.

You may be asking yourself, "How does this work?" or "Where's the connection between the options (single player) market and the futures markets (large pool)?" This is where the market maker comes in.

When a large player wants to buy calls, someone has to sell them to him/her. A market maker fulfills this need; but, by selling calls whenever customers want to buy, a market maker would become sorely exposed to sharp upside moves in the VIX very quickly. Therefore they then go into the futures market to hedge their short calls by buying long futures, thus driving the price of that future higher.

Depending on what month the original options trade occurred in more often than not indicates what futures contract month is purchased. This is how we end up with a futures curve, with different pricing for different months.

It should be noted that while market makers are in fact directional buyers, they are synthetic so to speak in that they are not making outright directional trades, only playing futures for hedging purposes. Thereby, through a chain of buying, selling, hedging, and otherwise you end up with a floating level of expected volatility for different months.

While this is not the only way that futures prices are influenced, this gives a broad overview of how volatility trades are different than typical equity trades; most notable is the fact that options strike prices are frequently not the expected price of a volatility product at expiration.

This is also the reason (coupled with a few other reasons) why technical analysis usually fails with the VIX...that, however, is a story for another day...



Read more: http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2010/11/26/benzinga644994.DTL#ixzz16b5al2lK