VIX Duration: Why It Matters

| About: REX VolMAXX (VMAX)

Summary

Traders need new tools to manage portfolios of VIX futures.

VIX Duration is a measure of a portfolio’s weighted average time to expiration.

VIX Duration may be useful to traders looking to quantify exposure to the VIX.

It's been a little over a year since the CBOE launched weekly futures on the VIX Index. As trading volumes begin to grow, now might be a good time to take a closer look to see how useful these futures really are.

Apart from expiring on a weekly cycle, the VIX weekly futures are all but identical to their monthly cousins. Like the VIX monthly futures, the weeklys trade on the Chicago Futures Exchange (CFE), a subsidiary of the Chicago Board Options Exchange (CBOE), and are cash settled against a Special Opening Quotation (NYSEMKT:SOQ) of the VIX Index calculated from S&P 500 option prices on the Wednesday morning of their expiry.

Apart from offering traders more frequent expiries to choose from, the most significant contribution of the VIX weeklys may well be more consistent access to shorter dated VIX exposure. Before their advent last July, at times the shortest dated VIX futures exposure had as much as 5 weeks until its expiration. Adding the weeklys has reduced this maximum time to expiry for the shortest-dated VIX futures contract from 5 weeks to just 7 days.

These new contracts have also introduced the possibility of trading very short dated calendar spreads. Traders looking to benefit from changes in the short dated VIX term structure can now buy or sell one expiry and take the opposite position in another expiry. This is particularly important when one considers the CBOE's research showing how shorter dated VIX futures contracts have demonstrated a higher beta to the VIX Index than have longer dated VIX futures.1 Previous articles have already explored the potential applications of these short-dated calendar spread trades.

But as traders begin adding weeklys to their portfolios there is a developing need for new tools to manage the unique risks that portfolios of VIX futures pose. One such metric steadily gaining popularity is "VIX Duration". VIX Duration measures the days to expiration of a single VIX product, or in the case of a portfolio, the weighted average time to expiration of the VIX products in that portfolio. I have footnoted a more detailed explanation but an example might be the best way to demonstrate how to calculate a portfolio's VIX Duration.2

If a portfolio held one weekly future priced at $16.00 that expired in 2 days, and simultaneously held one monthly future priced at $17.00 that expired in 16 days, the portfolio's VIX Duration could be calculated as follows:

To illustrate how durations vary it might be useful to consider the two most popular VIX index tracking portfolios, the S&P 500 VIX Short-Term Futures Index (SPVXSP) and the S&P 500 VIX Mid-Term Futures Index (SPVXMP). Both these indexes use a daily rolling theoretical portfolio of VIX futures to deliver a relatively stable VIX Duration. For example, the SPVXSP represents a portfolio that rolls a theoretical portfolio of VIX futures between the first and second month, achieving a relatively stable duration. However, VIX monthly futures may have either four or five weeks between expirations, as a result of the calendar, which can impact the stability of the VIX Duration for SPVXSP. For example, there were five weeks between the August 2016 expiry on the 17th, and the September 2016 expiry on the 21st , whereas there were only four weeks between the September 2016 expiry and the October 2016 expiry on the 19th. As a result, the duration of the SPVXSP can vary between 28 and 35 days-for example, SPVXSP had a duration of 35 on the 17th of August and 28 on the 21st September. The same applies to the SPVXMP medium term index that rolls futures between the 4th and 7th months, resulting in a varying duration of around 150 days.

There is still no index tracking a theoretical portfolio of weekly futures. However, a theoretical portfolio can be constructed by continuously rolling from week 1 to week 2 futures in a similar way the SPVXSP rolls month 1 and month 2 futures. If that were the case, the duration for that weekly index would be just 7 days, considerably shorter than the popular SPVXSP index. Furthermore, because the number of days in a week remains constant - unlike the number of weeks in a month - the duration of a weekly index may not only be shorter, but also more stable than the duration of a monthly index.

So why might duration be important to traders? As with other asset classes, such as fixed income, VIX Duration may be one way of expressing a portfolio's exposure in a consolidated manner-lower durations indicating shorter dated exposure to the VIX, and higher durations longer dated exposure to the VIX. Perhaps more importantly, VIX Duration may prove to be a useful measure of sensitivity to the VIX. Recently published research by the CBOE shows that shorter dated VIX futures have historically demonstrated a higher beta to the VIX Index itself. If the CBOE observation continues to hold, portfolios with significant exposure to shorter-dated VIX futures may also demonstrate a higher beta to the VIX, and VIX Duration may provide a useful metric for quantifying such overall exposure.3 As a result, traders looking to increase exposure to the VIX may consider shortening the VIX Duration of their portfolios.

Footnotes

  1. CBOE (2016) Beta of VIX futures to the VIX index as a function of time to Expiration. Available at: CBOE.com
  2. “VIX Duration” for a portfolio may be calculated as the sum, for all instruments held by the portfolio, of [a] theVIX Duration for each instrument held by or tracked by the portfolio that provides exposure to VIX Futures Contracts, multiplied by [b] the ratio of [i] the portfolio’s notional exposure to such instrument divided by [ii] the total notional exposure of instruments held by the portfolio that provides exposure to VIX Futures Contracts. “VIX Duration” for a VIX Futures Contract is calculated as the number of calendar days between the current day and the date such VIX Futures Contract expires.
  3. CBOE (2016) Beta of VIX futures to the VIX index as a function of time to Expiration. Available at: CBOE.com

Disclosure

The use of derivatives, such as futures contracts, swap agreements and options, presents risks different from, and possibly greater than, the risks associated with investing directly in traditional securities. Changes in the value of a derivative may not correlate perfectly with the underlying security, asset, rate or index. Gains or losses in a derivative may be magnified and may be much greater than the derivative’s original cost. The derivatives may not always be liquid. The VIX Index is not directly investable. As a result, the behavior of a VIX Futures Contract may be different from traditional futures contracts whose settlement price is based on a specific tradable asset. Several factors may affect the price and/or liquidity of VIX Futures Contracts.

The information contained herein does not constitute an agreement to enter into any business arrangement, or an offering or solicitation for sale of securities. It is not intended that anything stated herein should be construed as an offer or invitation to buy or sell any investment vehicle or for potential investors to engage in any investment activity. All information provided by this investment case is impersonal and not tailored to the needs of any person, entity or group of persons. Nothing contained herein constitutes tax, accounting, regulatory, legal, insurance or investment advice.

These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. The authors do not guarantee the accuracy, completeness, timeliness or availability of the content and are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the content. The content is provided on an “as is” basis.

The CBOE Volatility Index (the “VIX”) is a product of S&P Dow Jones Indices LLC (“SPDJI”) and is based on the CBOE VIX methodology, which is the property of Chicago Board Options Exchange (“CBOE”), and has been licensed for use by REX Shares, LLC (“Licensee”). S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); CBOE® and VIX® are registered trademarks of the CBOE. The CBOE VIX methodology and the trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Licensee. Any investment product or strategy based on the VIX is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, or CBOE and none of such parties make any representation regarding the advisability of investing in such products nor do they have any liability for any errors, omissions, or interruptions of the Index.