Understanding Volatility Derivatives: VIX, Futures, and ETNs

A comprehensive guide to VIX futures, options, and volatility-linked ETFs—from foundational concepts to advanced trading implications.

Originally written years ago, this deep dive into volatility derivatives remains just as relevant today. From the structure of VIX futures to the quirks of volatility ETFs, the insights here are essential for anyone trading or hedging with volatility products.

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This article was originally published as part of an eBook in 2013.

In 1993, the CBOE formally published the Volatility Index, VIX – the first and still the foremost index of volatility in existence. But the mere publication of VIX was just something traders could observe; they could not trade it. Eventually, though, in 2004, listed futures on VIX were introduced. The CBOE created its own futures exchange, the CBOE Futures Exchange (CFE) for this purpose. Futures were listed on both realized volatility (variance futures) and on implied volatility (VIX futures). Variance futures have not proven to be very popular with the populace who trades listed derivatives, but VIX futures have. Listed options on VIX were introduced in 2006. These products allowed listed option traders to address volatility directly for the first time. For those who don’t trade derivatives, the volatility Exchange Traded Note (ETN) – VXX – was listed in 2009.

These have been some of the most successful new products ever introduced, and their popularity continues to grow among both speculators and hedgers – those looking to protect stock portfolios.

Historical and Implied Volatility

Most of the time, actual volatility declines in bull markets and increases in bear markets. One reason is that, in bull markets, stocks tend to advance almost every day. But, in bear markets, declines are often punctuated with sharp, short-lived rallies, and so the standard deviation of the daily price changes is much greater. In fact, novice investors and certain members of the media interchange the terms “volatility” and “price decline.” They might say “the market is volatile,” when what they mean is “the market is down.” This is incorrect, of course.

Implied volatility, however, is strictly a component of option pricing, and is a forward-looking measure. It is the volatility that one would have to use in a theoretical model (such as the Black-Scholes model) in order for the model’s estimate of “fair value” to be equal to the current market price of the option. There is not a specific formula for calculating implied volatility; rather, it is an iterative process.

Calculation of VIX

The original CBOE Volatility Index calculation was released in 1993. It used the weighted implied volatilities of four series of OEX options, centered about the current OEX price – one strike above the OEX price, one below, in each of the first two expiration months.

By 2003, SPX options had become the most liquid index options, so the CBOE revamped the calculation of VIX. The “old” VIX remains – its symbol was merely changed to VXO. The “new” VIX was based on SPX options, and incorporated nearly all of the strikes trading in the first two expiration months. In the vernacular, it is said that the “new” VIX is based on the “strips” of options expiring in the first two months. The actual formula, which is complicated, can be found on the CBOE web site, along with other papers on the subject.

Both the old and new VIX are 30-day volatility measures. That is very important, for longer term derivatives, expiring many months in the future will not track VIX well, for this very reason. What this 30-day estimate means, in mathematical terms, is that the two strips of SPX options that are used in the VIX calculation have a different weighting each day. As time passes from one month to the next, the strip of SPX options in “near” month gets less weight and the strip in the “far” month gets more.

The VIX calculation is versatile. It can be applied to any set of options where continuous markets (bids and offers) are being made in the two strips of options in the two front months. As a result, a VIX-like calculation of volatility can be made for nearly every listed stock, index, or futures options. In recent years, the CBOE has begun publishing VIX calculations, and in some cases trading futures and options, on gold, crude oil, and the Euro (foreign currency). These used the options of the popular ETF’s GLD, USO, and FXE, respectively. Also, VIX calculations are being broadcast on a number of other ETF’s and some individual stocks – which, at this time, include Apple (AAPL), Amazon (AMZN), Goldman Sachs (GS), Google (GOOG), and IBM (IBM), and the following ETF’s: Emerging Markets (EEM), China (FXI), Brazil (EWZ), Gold Miners (GDX), Silver (SLV), and Energy (XLE).

It will become necessary, if it isn’t already, to qualify what VIX one is talking about. For years, VIX meant the calculation based on the SPX options. But, it really is likely to be called “SPX VIX” as time progresses. To differentiate it from “Gold VIX,” “Apple VIX,” and so forth.

Listed Volatility Futures

In 2004, the CBOE created its futures exchange – the CFE – with only two products in mind: listed futures on historical and implied volatility. Implied volatility futures – or VIX futures, as they are commonly known – have proven to be the far more popular product.

Do not skip this section if you are planning on trading any derivative volatility products. Even if you think that you might have no interest in trading VIX futures – only options on VIX – you must understand the futures on VIX in order to understand the options on VIX.