By Langyu Wang

The Sudden Demise of Two Inverse-VIX ETNs

During the extended hours trading on Monday, February 5th 2018, two Exchange Traded Notes (ETN) issued by Nomura and Credit Suisse, which once valued at $289.4 Million and $2.2 Billion, respectively, have fallen victims to an unprecedented sudden surge of volatility as a result of dramatic equity sell-off.The panic was arguably triggered by a fear of sooner-than-expected inflation adjustments and more interest rate hikes brought into light by a Federal Reserve’s report on personal income and outlays published a trading day ago. The two aforementioned ETNs lost more than 95 percent of their value in less than 30 minutes as the CBOE VIX Index spiked to 37.32 from last Friday’s close of 17.31, a whopping 116% increase. Volatility typically rises as stock prices fall and as tumult spread on Monday, whoever was betting on the tranquility of the market shouldered a blunt hit in their portfolio.

So how do investors trade volatility and why do they do it? Before we go into detail, we need to know what the VIX index and VIX futures are.

The VIX Index

The VIX Index is a convoluted way to dynamically and mathematically depict the real-time market index on the implied volatility of SPX futures, which is a forward-looking indicator to measure investors’ expectations on how much volatility they will see in the market. It was introduced in 1993 with two purposes in mind. The first purpose was to provide a benchmark of the market expected short-term volatility to facilitate comparisons with historic levels back to January of 1986. This is particularly significant as the infamous 1987 flash crash provided the worst single-day stock market crash since the Great Depression. It also provided a relatively fair and comprehensible gauge on the market anxiety. The second was to create an index upon which the future and options can be based on, just like LIBOR to short-term lending contracts and SPX to S&P 500 futures. As such, Whaley (2009) pointed out that similar to the concept that a bond’s yield is implied by its current price and the expected future return of the bond over its remaining life, the VIX is implied by the market spot prices of options on the S&P 500 Index (SPX) and represents expected future stock market volatility over the next 30 calendar days.

At the dawn of VIX Index’s introduction, the calculation of VIX was denominated by the option prices of S&P 100 Index (OEX) and based on the prices of eight at-the-money OEX calls and puts calculated by the Black-Sholes option pricing model. Over the years, when SPX’s trading volume dwarfed OEX’s(reasons for which are still under debate)and the index options market became a de-facto portfolio managers’ venue to insure and hedge their exposures to the systematic risks, out-of-money and at-the-money index puts were outselling calls by more than 70%. On September 22, 2003, the CBOE changed the VIX calculation in such a way that it could adapt to the new options market climate. This change got rid of the old VIX’s model dependency and incorporated the SPX options. Additionally, the new VIX can now integrate information from the volatility smile, a graph shape that comes from plotting the strike price and implied volatility of a group of options with the same expiration dates by using a wider range of strike prices, revealed by Carr and Wu (2006.) Moreover, the inclusion of the out-of-money put options in the calculation, as they contain vital information regarding the demand for portfolio hedges. This inclusion not only better depicted the market volatility expectations, but also made the VIX less sensitive to a few index options, hence supposedly less susceptible to manipulations. The changes can be seen in the calculation formula provided in the CBOE VIX Whitepaper. To make things clearer on top of the confusing footnotes, Luo and Zhang (2012) explained that F is the implied forward index level derived from the nearest-the-money index option prices by using put-call parity and K0 is the first strike that is below the forward index level. Ki is the strike price of the i th out-of-money option, Ki is the interval between two strikes, defined as ΔKi = (Ki+1 − Ki−1)/2. In particular, ΔKi is the difference between the lowest and the next lowest strikes for the lowest strike and is the difference between the highest and the next highest strikes for the highest strike. The calculation only uses out-of-money options except at K₀, where Q (K0) is the average of the call and put options prices at this strike price.

Snapshot of the Current VIX Index Whitepaper Published by CBOE

In a simplified way to interpret this formula, when more portfolio managers expect an unfavorable interim future, they will buy more options to hedge against risks hence a higher level of the summation of Q(Ki) times ΔKi for all strikes, which is the strike contributions to VIX from all the options with non-zero bids. After subtracting the time-adjusted forward index priced accounted for both the current and future cycles, we have an increased and subsequently a higher VIX level.

Due to the property of monitoring the options market in real-time and the customary practice of using options--mostly puts--as insurance to hedge against unexpected events, the VIX has been dubbed the “investor fear gauge.” There is a positive correlation between unfavorable and unexpected events and VIX peaks since the birth of VIX in the late 80s. This phenomenon is caused by panic investors frantically buying put options when black swans broke out, which drastically increased the put option prices in a relatively short time window, hence a much higher VIX level.

Since we have familiarized with the VIX index by now, it is obvious that just like the S&P 500 Index, VIX is an index that indicates the market implied volatility without trading properties. We need another leap to trade volatility, which leads us to the invention of VIX futures.

VIX Futures

After the mass implementation and utilization of computers and algorithmic trading strategies in the 80s, the volatility climate has never been the same—market seems to be more and more volatile during the technological revolution. Anxious institutional investors started to peek into ways to hedge against and speculate on market volatility. The first “pure” volatility derivative was introduced in 1993 by Michael Weber, a UBS banker. This invention, known as “variance swap,” was used as a hedge for the Swiss bank’s UK market exposures. This swap was quickly introduced to Wall Street and had its moments of success when the Asian Financial Crisis deteriorated and LTCM collapsed.

As the VIX was getting increasingly popular as a “fear gauge,” after a series of unfortunate events took place, a surging amount of interest in using the VIX as a direct proxy for hedging activities had taken place due to the complexity and arduously dynamic hedging processes of the “variance swap.” Only the big banks with the best talents could effetely pull it off, but others were not willing to stay on the sideline of volatility trading. Legend has it that the Dallas Mavericks owner and entrepreneur Mark Cuban wanted to buy some protections on his proceeds of selling Broadcast.com, an internet radio and streaming company, to Yahoo for a whopping $5.7bn at the heap of the dotcom bubbles. His Goldman Sachs broker immediately recommended the variance swap, but the pitch turned out to be unfruitful, as the billionaire wanted to trade on the “fear index” directly. Cuban’s frustrated, but business-savvy broker divulged this information to a colleague who ended up calling CBOE and managed to persuade CBOE to tweak VIX’s methodology and make tradable futures contracts with better feasibility. On March 26, 2004, CBOE initiated the first-ever listed futures contract on the VIX index on the CBOE Futures Exchange (CFE.) At the beginning, it seemed that VIX futures were still arcane and complex, causing limited trading volume. For example, the open interest of VIX futures on February 28, 2005 was only 9,240, translating to a nominal market value of $112mn. Such low enthusiasm did not last long, for when the 07-08 Financial Crisis took place, VIX futures became the epicenter of hedging activities and ascended into stardom.

One of the key advantages of using VIX futures over variance swaps is that VIX futures enjoy all common properties that a futures contract has and most of the sophisticated investors and hedge fund managers have sufficient knowledge pertaining to futures contracts. Trading volatility has finally become a game with a level playing ground and the investors did not hesitate to jump on the bandwagon. Here are some key specifications of the VIX futures according to CBOE (2018):

1. Trading hours:

2. Underlying value: 10 times the VIX index value, disseminated by the CBOE through Options Price Reporting Authority (OPRA) under the ticker “^VXB” and through the CFE under the symbol “VBI.”

3. Contract size: $100 times VXB thus a contract multiplier of 1,000 by the VIX value.

4. Minimum tick size: 5 cents. As such that the contract minimum value change will be in $5 intervals.

5. Contract months: Frist in May, June, August, and November but with two near-term and two additional months on the February quarterly cycle.

6. Last trading date: Tuesday before the 3rd Friday of the month.

7. Settlement date: Usually the Wednesday prior to the 3rd Friday of the month. If that Wednesday or the Friday that is 30 days following that Wednesday is a CBOE Options holiday, the final settlement date for the contract shall be on the business day immediately preceding that Wednesday.

8. Delivery: In cash amount on the business day immediately following the final settlement date. The cash settlement amount on the final settlement date shall be the final mark to market amount against the final settlement value of the VX futures multiplied by $1000.

9. An example: Assuming you are on the selling side of the VIX futures for 1 contract at the settling VIX of 18. The VIX index closed at 13 then your potential loss/margin call for today is $5,000.

Contango and Backwardations

Since the VIX futures are futures contracts, it is important to understand what the current term structure of the contracts is. There are two: contango and backwardation. The term structure is a fundamental theory developed in respect to the price changes in relation to the contract time to expire. When the market is in contango, future contracts with a longer time until expiration are traded at a higher price or settling level in comparison with the shorter expiration. Here is an example of a contango:

On the contrary, when the market is in backwardation, the contracts with shorter expiration are traded at a higher price or settling level due to reasons like an unexpected short-term shortage of underlying spot goods/products. Here is an example of backwardation market term-structure on October 16th, 2008 when the market was heavily sold due to worsening prospects of the economy from Financial Crisis.

October 16, 2008 Was One of the Worst Trading Days in History When the Market Was Experiencing the Full-on Rage of Financial Crisis

When the futures market is in contango, the selling side of the VIX futures will be benefitted since the contracts are settled at a premium due to longer expirations. However, if the contracts expired when an unexpected event happened, and the market deemed it to be unfavorable, more puts will be bought so that the implied volatility will translate into a much higher VIX index and subsequently a peak in the near-term VIX futures prices. As the market expected in the longer-term that the market will recover so the VIX futures prices with longer expirations will be cheaper than the ones with shorter ones. This is the mechanism behind backwardation. As a result, sellers of protection when the market is in backwardation will suffer a hefty loss.

The primary reason why there are buyers of VIX futures, regardless of inevitable losses due to time decay of the futures contracts, is to hedge against the systematic risk of the market and protect themselves from tail risks. However, thanks to the post-crisis global central banks’ Quantitative Easing and the subsequent low-interest rate and accommodating monetary policies, a 9-year bull equity market led to the ever more widespread practice of selling VIX futures due to the grotesquely asymmetric risk and returns. In a journal published by McGraw Hill Financial, it was revealed that from 2004 to 2014, 83% of the days that the VIX futures are traded were in contango (Steadman.) We can clearly see that after 2009, except for the time when rating agencies downgraded the U.S. treasuries in 2011, mostly the market was in contango, indicated by the blue sections, and VIX futures sellers were bringing in egregious returns by shorting theta.

VIX ETPs

Wall Street’s intellectuals always align quickly with the trend that generates lucrative returns. Financial engineers from large banks enveloped the potentials of democratizing access to the volatility trades by constructing exchange-traded products (ETP) based on the VIX futures. In 2009, British Investment Bank, Barclays, built the first volatility ETP to cater smaller and non-institutional investors’ appetites in trading volatilities like stocks. By now, there are 52 volatility-linked ETPs available for ordinary retail investors to trade.

In theory, these ETPs follows a pricing strategy by following an index of an unlevered, rolling long(^SPVXSP) or short(^SPVXSPIT) position in the nearest month and second nearest month of VIX futures contracts. It rolls continuously throughout each month, from the first-month VIX futures into the second-month VIX futures contracts. The Index rolls a portion of its positions on a daily basis. One of the effects of daily rolling is to maintain a constant weighted average maturity for the underlying futures contracts. Certain futures contracts, like those on the VIX, specify a date for settlement in cash based on the price of the underlying asset or index. Once this date is reached, the futures contract “expires.” For instance, the Index shorting VIX futures operates by selling VIX futures contracts with a nearby settlement date and purchasing VIX futures contracts which settle on a later date. Index longing VIX futures does the exact opposite by buying contracts with a nearby settlement date and selling contracts with a later settlement date. The roll for each contract occurs on each Index business day according to a pre-determined schedule that has the effect of keeping constant the weighted average maturity of the relevant futures contracts. The constant weighted average maturity for the futures underlying the Index is one month. Detailed calculations, according to the prospectus of an example volatility ETF, SVXY, are as follows:

To put in layman terms, we can use the aforementioned process to artificially replicate a constant maturity future for VIX futures with a maturity of 30 days by calculating the weighted average of two near-term futures called “TDWO” and subsequently the “S&P 500 VIX Short Term Futures Index” (^SPVXSP). In practice, algorithms calculate this index every 15 minutes about 20 days a month instead of 30, because we cannot rollover positions when the market is not open. ETPs that follow this index usually will rebalance their portfolio once a day, from 4:00 to 4:15 P.M. EST. ETPs longing the VIX futures will follow ^SPVXSP and shorting VIX futures ETPs will track the “S&P 500 VIX Inverse Short-Term Futures Index” (^SPVXSPIT.) By borrowing at the rate issuers charge, ETPs can also leverage their exposure to the VIX futures. It is also worth noticing that since TDWOs are replicating the square of volatility and the VIX futures are volatility, market makers/VIX ETP Issuers are also exposing themselves to the risk of convexity.

Here is an example of VIX-denominated ETPs ordered by the size of its net asset value as of March 2012.

The most updated list of VIX ETPs can be found at here.

What happened to XIV?

As mentioned at the beginning, XIV lost more than 90% of its value in the after-hours on Feb 5th, 2018. Since we have covered all the foundations of volatility trading, now we can dig into this memorable lesson for volatility traders.

XIV is the ticker symbol of an ETN that tracks the S&P 500 VIX Inverse Short-Term Futures Index, the index that tracks the shorting side of TDWO. This fund must rebalance itself once a day from 4:15 to 4:30 P.M. EST, when the settling price for the VIX futures are typically the most updated and transparent with the largest futures liquidity in a day. This rebalancing process will lock in the net gain/loss at exactly -1 times the net gain/loss of TDWO from the previous trading day. However, this creates a big problem called “short gamma effect,” which is a common epidemic among ETPs that have leverage below 0 and more than 1. Let’s see an example of short gamma problem:

Assume today the XIV, with an NAV of 100, consists of 5 shorted positions of TDWO, closes at 20 at 4:15 P.M EST. At the market close of the next day, TDWO went up 20% to 24, thus a loss of20 (5*4) occurred. Net loss today is -20% and the NAV of XIV goes down to 80. In order to keep the NAV change rate the same as the TDWO change rate, similar to delta hedge, XIV needs to lower its position to3.33 (80/24) contracts. This means XIV needs to long 1.67 (5-3.33) contracts of TWDO. On the next day, TDWO drops from 24 to 20per contract. XIV’s NAV goes up to 93.33 (80+3.33*4). Even though the net gain of NAV of the XIV is 16.67% (3.33*4/80), which is perfectly -1 to the net loss of TDWO 16.67% (4/24), the NAV went down from 100 to 93.33, despite the underlying TDWO remaining at 20.

From a mathematics perspective, short gamma effect of erosion on XIV NAV over consecutive rebalancing makes sense, as well. Here is the end value of XIVᵗ and beginning value XIV₀ with a leverage of λ:

where σs is TDWO volatility and rs is the returns contributed by contango. Essentially, the XIV’s returns are negatively impacted by σ, resulted by short gamma and positively impacted by rs, resulted by contango. Here is a graph on the XIV NAV in relation to both effects:

We can see that the net effects of short gamma are countered by the contango accumulation entirely. The 30 days VIX futures pricing (TDWO) has never been up to over 100% since the inception of XIV. Nonetheless, the damage of short gamma is grave. Most of the time, the VIX futures market is in contango, so in the long-run, the carrying returns outweigh the costs. We can see that in June 2016, there was a stark increase of damage done by short gamma. That was because the UK announced the unexpected Brexit. Since the single day TDWO increase was limited within 100%, VIX barely made it through. Ever since, the returns on contango recuperated the losses done by that Brexit turmoil. In 2017, when there was historically low volatility throughout the year, short gamma costs were even lower and the contango returns were more substantial, which skyrocketed the returns of XIV. We can see from the candle chart below, XIV went from less than 20 dollars at the beginning of 2016 to a peak of 145 in early February 2018. This created another issue—more and more less-educated and unsophisticated retail investors rushed into the buoyant XIV market. Most of them were unaware of the short gamma effect or simply chose to ignore it because of their cognitive biases. This over-bought significantly increased XIV positions on the selling side of the VIX futures. The XIV at the beginning of 2018 was behaving like an increasing-speed train storming into mountainous areas with zigzag rails ahead.

Below is a line chart of TDWO pricing (red), VIX ETP net vega (green), and the total VIX futures net vega (blue). We can clearly see that after Brexit, the net long VIX futures peaked and the TDWO gradually declined to its lowest of approximately -190, with all net negative VIX futures vega at the beginning of February in 2018.

This environment created two perfect catalyzers for the implosion of XIV:

1. Unprecedentedly low TDWO, which can easily go up 100% in a day and it did.

2. Unprecedentedly negative net vega exposure on VIX futures resulted by overcrowded sell-side VIX futures open interests.

After another period of historical returns on S&P 500 in January 2018, largely thanks to the market optimism and stellar macroeconomic indicators upon the passage of the tax cut bill, the market finally caught on to the idea that the new hawkish Fed chairman Jerome Powell eventually will increase the interest rate in fear of an overheated economy at a faster pace than the current market digested. This unexpected certainty of rising interest rates under the current highly-levered environment is generally considered a calamity for the equity market. As a Federal Reserve report published a higher-than-expected salary growth in January, which indicates more inflation pressure, the market sell-off began on Feb 5th and intra-day TDWO consequently shot up to 20 from 15. As we have mentioned before, this meant XIV must buy in VIX futures of about 33% of their NAV to balance out in 15 minutes after 4:15 P.M. on the same day. However, due to the market-wide negative vega on VIX futures and a startled market, virtually nobody was willing to sell VIX futures at a relatively lower settlement price. At the close, XIV was short about 200,000 futures. Running out of options, XIV had to raise the bid price and in just a few minutes TDWO was sold at 29.5. A day before, it traded at 15.19 when the market closed. What we had witnessed was a short gamma squeeze on steroids.

Credit Suisse was considering the potential downgrades from the rating agencies, so it was a calculated decision to liquidate the XIV because an ETN that was more of a bond as opposed to equity. Inverse-VIX ETFs that are not that dependent on the credit ratings, like SVXY, merely escaped the fate of liquidation. Not long after, Proshares, the issuer, slashed SVXY’s exposure to the reverse of the volatility index by half and UVXY’s exposure to the long volatility by 25%. This reduction in leverage, in theory, should lower the chances of closures in anticipation of future VIX spikes and short gamma squeezes.

Criticisms of the Volatility Trading

VIX ETPs Predictability

The biggest flaw of the VIX ETPs is its predictability. As publicly disclosed in their prospectuses, these products need to buy or sell VIX futures in response to market moves, as well as investors’ inflows and outflows. To be exact, the issuers of VIX ETPs need to virtually do most of their trading by algorithms in a brief time window of 15 minutes at 4:15 P.M.EST every trading day. When the market closed with significant changes in VIX futures, the VIX ETPs’ humongous rebalancing orders are sitting ducks in a hunting field filled with shrewd investors’ snipers. Generally, probability of execution increases when it gets closer to 4:15 P.M. But, the crowded trade orders in such a short amount of time have the potential to skyrocket the settlement price, which is terrible news to ETP investors on the wrong side of trades. This predictability under the zero-sum environment feeds to an ecosystem that does not yield any positive impacts to the hedging activities but exacerbates into an unfair gambling house.

VIX Index Manipulation

It is no secret nor under debate that the VIX index was and still is under manipulation. This issue was first brought into light by a paper published a decade ago indicating that the VIX index can be gamed and artificially brought higher. In the 07-08 Financial Crises, it was reported that small tech-savvy hedge funds managed to bring in exorbitant returns by exploiting the VIX index calculation loopholes. SEC had set up a special team to investigate but over the years it yielded little to no results. In 2017, two researchers from the University of Texas at Austin (M. Griffin, Shams) found sound statistical evidences to prove the existence of VIX index manipulation. For instance, SPX options prices at settlement systematically deviate from the mid-quote of the previous close across the strike prices. After settlement take place, the prices usually revert back toward the mid-quote. Moreover, the study revealed the mechanism behind it. Since only out-of-money (OTM) SPX options are being used in the VIX calculation, traders trying to manipulate the VIX index will send in aggressive buy or sell orders of SPX options prior to 8:15 A.M. EST to effectively compel a largely-negative bid-ask spread, thanks to the rule that no VIX-related orders can be submitted from 8:15 to 8:30 A.M., which will negatively affect out-of-money SPX options and positively affect In-the-money options when the market opens at 8:30 A.M. This phenomenon is consistent with the idea that manipulators have no incentives to influence in-the-money (ITM) SPX options. Such negative impact on the OTM SPX options will translate into an artificially elevated or lowered VIX index henceforth manipulators can get out soon after the market opens and reap their profits. The graphs below are snipped from the research, which indicated the increasing trend of SPX prices approaching 8:15 A.M. followed by a downturn in price even though the trading volume are increasing. Such phenomenon backs up the authors’ theory of VIX index manipulation mechanism.

It is also worth noticing that there can be manipulators on different side of the trade, forming a tug-of-war where some traders are pushing the SPX options up while others are pushing them down. When the two forces are similar in magnitude, manipulation effects are not significant as the two forces balanced themselves out.

Even though this manipulation mechanism was believed not to be the direct culprit behind the sudden demise of the two Inverse-VIX ETPS during the extended-hour trading on Feb 5th, 2018. We have explained earlier that the real cause of that event was an unprecedented short gamma squeeze. Nevertheless, right after the VIX-mageddon, a whistle-blower, believed to be holding “senior positions at some of the largest investment firms in the world,” told U.S. regulators such a VIX manipulation scheme existed and had costed investors hundred of millions of dollars a month.

Aggressive buy/sell SPX orders from the pre-trading time is not the only ways to affect VIX index. On April 18th, amidst relatively tranquilized market, VIX surged over 10 percent just a few minutes after the monthly VIX futures auction. Financial Times later reported that the surge was the result of apparently outlandish bets been placed on the SPX options. A trader or traders paid $2.1 mn for SPX put options with a strike price below half of what S&P 500 index (^GSPC) was at, which means that only when the S&P 500 drops more than 50% will this option break even. Unless we experience a recession comparable to the 1929 Great Depression in less than 30 days, it is sufficing to say that manipulators behind this scheme were prepared to lose money on the options in exchange of returns on the VIX positions they own.

Feedback Loop

This is an issue largely been observed with increasing amount of evidences. However, it is still a challenge to come up with a scientific theory to corroborate the feedback loop issue clearly due to big questions like whether the growth of VIX ETPs has affected the VIX market in a similar way to the single stock market. My personal guess on the mechanism behind this conundrum is as follows:

VIX futures are mostly determined by the OTM puts. Before the inflection point passes, most of the investors are not worried about their exposures. As a result, VIX index remained at a lower level due to both low open interest and price of the puts. These two forces will generate an inorganically-lowered VIX index. When black swan broke out, a substantial amount of the hidden demands on puts will be reflected and such demands on protection will drastically increase the VIX index in short time window. Consequently, VIX futures denominated by the VIX index will rise. Then the rising VIX futures triggered the massive inverse-VIX ETPs to buy VIX options so that they can rebalance in only 15 minutes. This madness of algorithmic trading will create a shortage in VIX futures and astronomically increase the VIX futures settlement price. Meanwhile, we cannot rule out manipulators’ influence on the sudden disappearing liquidity of VIX futures. As a result, panic investors found out the VIX futures market is promptly in backwardation, which will encourage them to buy even more puts to protect their positions. Such behaviors further increased the implied volatility on puts and further hampered the VIX index and later the VIX futures then the rebalancing activities of inverse-VIX ETPs. Now we have a vicious cycle that echoes and magnifies the panic of the market. Such pro-cyclical behavior might also create a self-fulfilling prophecy at a much larger scale as most of the risk managing models used by the banks and institutional investors are more or less resembling to each other’s.

The only way to break this vicious cycle is by the prevailing number of market orders from investors who are brave enough to catch falling knives and buy the dips. However, we have so many troublesome events for the rest of years including deteriorating Russian Probe, prospects of an impending trade war with China, global selloff of U.S. Treasuries due to the relentless and insatiable U.S. government spending behaviors at a bizarre tax cut timing, global central banks to reverse the QE by reducing balance sheet, which consequently an increasing interest rate environment and the U.S. Congressional Elections, etc. It is almost a certainty that the rest of 2018 will be a highly volatile year. More and more investment bank analysts are lowering their long-term growth expectations with a higher interest rate. Such combination is not indicating a promising future. Therefore, it is not outrageous to say that another VIX-mageddon caused by an even higher volatility spikes might happen again in 2018.

Conclusion

There are undoubtedly unpleasant aspects of the volatility trading that desperately needed to be addressed in a timely manner. Just like we are still looking for an adequate equilibrium of passively-managed and actively-managed strategies in the equity market, the search for the appropriate size of volatility trading positions for the current market is still under researches. However, we should always remember that there are no bad weapons, only incompetent soldiers with insufficient knowledge of their weaponry. Volatility trading and the democratization of volatility tools can be a great weapon or shield for sophisticated investors who has done their fair share of study. It is advisable to use them as emergency hedges against expected short-term and sudden increase of systematic risks instead of speculation tools.

Updates on the Predictability of VIX:

The Virtu Financials, Inc. CEO and Director, Douglas A. Cifu, addressed a question from an analyst from Evercore ISI on whether the VIX is still a good gauge of volatility during the Q1 2018 earnings call. He replied:

"...I said on the last call and I'll say again, our -- my experience and our experience is more with the futures exchange there, and the way that those -- the way that they manage their tasks and closing cross and settlement is like any other future exchange we've ever interacted with, it's very transparent. I think all the participants that are experienced there understand how it works. I think, unfortunately, there was a suitability issue with regard to folks that were holding [SVXY] and the XIV product. It's not an investable product, it's a trading product. So if you're holding it for a year because you wanted to be short volatility, that was probably a really bad idea and is particularly a bad idea on February 5th. The closing price at 4:00 has little relationship to what the settlement price is going to be because futures exchanges settle at 4:15. And market makers and professional traders know that and retail investors and others don't. So again, are there issues there around suitability of that regulators, I'm sure we'll look at absolutely. Is that an investor education question? Clearly, it is. It's fundamentally the product flawed and that Cboe in my humble opinion do anything wrong, I think the answer to that is no."

Citations:

Whaley, Robert E. “Understanding the VIX.” The Journal of Portfolio Management, vol. 35, no. 3, 2009,

pp. 98–105., doi:10.3905/jpm.2009.35.3.098.

Luo, Xingguo, and Jin E. Zhang. “The Term Structure of VIX.” Journal of Futures Markets, Wiley-Blackwell,

16 Aug. 2012, onlinelibrary.wiley.com/doi/pdf/10.1002/fut.21572.

Carr, P., & Wu, L.-R. (2006). A tale of two indices. Journal of Derivatives, 13, 13–29.

CBOE. “VIX Contracts Specifications.” Contract Specifications, CBOE, 2018, cfe.cboe.com/cfe-products

/vx-cboe-volatility-index-vix-futures/contract-specifications.

Reid Steadman. “The Volatility Seller's Premium: When It Is Available And When It Is Not.”

Insights Dedicated to Investment Trends and Index Innovation, June 2014, p. 5.

John M Griffin, Amin Shams; Manipulation in the VIX?, The Review of Financial Studies, Volume 31,

Issue 4, 1 April 2018, Pages 1377–1417

*Special thanks to Julia Wolfe—a wonderful Writing Coach from the Business Communication Center of School of Business, University of Kansas, who generously shared her time helping me proofread.

Investments

An Elementary Introduction to Volatility Trading