A competitor to the VIX would certainly help reduce the high fees associated with trading VIX products, writes Jay Soloff.
When it comes to trading volatility, The Cboe Volatility Index (VIX) has long held the crown as the most viable product on the market. Products based on the VIX, the S&P 500 Implied Volatility Index, have been one of the most notable additions to the trading universe in the 21st century. In fact, the Cboe Global Markets (CBOE) introduction of tradeable VIX products has essentially turned volatility into its own asset class.
Consequently, the VIX is such a popular product that it basically has no competitors. That’s good news for CBOE, which can charge a premium for trading fees on VIX futures and options. However, clients who trade VIX products (including exchange traded funds) have to eat those costs or pass them on to the end user.
A competitor to the VIX would certainly help reduce the high fees associated with trading VIX products. Depending on how the product is designed, it could also offer some interesting arbitrage opportunities and help grow the volatility asset class even more.
Yet, any competitor to the VIX’s stranglehold on the volatility trading space will face an uphill battle. The VIX has maintained its leadership for a reason – CBOE did an excellent job of designing the product.
First and foremost, the VIX uses prices from SPX options, or options based on the S&P 500 index (though initially it was based on the S&P 100). They are the most popular institutional options product in the world, and CBOE has exclusive rights to create products based on the index. Moreover, the methodology used to calculate the VIX price is precisely what the industry needs.
In a nutshell, rather than base VIX prices on at-the-money options in SPX (known as the at-the-money straddle), the calculation uses a method akin to a variance swap. The details of this process are not important within the scope of this article. The key is that a variance swap essentially offers pure exposure to volatility, while a straddle calculation involves other forms of risk. The industry generally prefers the VIX to be as pure a play as possible on volatility.
But despite the qualities inherent in the VIX, the index and its derivative products do have their problems. Liquidity has at times been an in issue with SPX in certain less commonly traded strikes. SPX options are expensive from an absolute value standpoint, so they tend to be used primarily by institutions. It means the open interest per strike may not always be widely dispersed. This lack of dispersion can lead to the occasional odd print in the VIX during more tumultuous trading periods.
While I mentioned the high fees for trading VIX products right off the bat, the most notorious issue with the VIX may be the settlement. The CBOE, still dealing with lawsuits concerned past settlement problems, has improved the process in recent months. However, the process still has problems.
The biggest issue is that VIX settlement is based on a product (VIX futures) traded on just one exchange. A well-timed large order in VIX futures can potential alter the settlement price during the final auction process, allowing big players to game the system.
So, how can a competitive volatility product retain the benefits of the VIX while addressing its few shortcomings? That’s where the SPIKES index comes in.
The SPIKES Volatility Index (SPIKE) started trading options on Feb. 19, 2019. The product is a collaboration between the MIAX Options Exchange (a CBOE competitor) and T3 Index (an indexing firm). SPIKES is similar to the VIX except the calculation is based on SPDR S&P 500 ETF (SPY) options instead of SPX options. SPY is the most popular ETF in the world. It trades an average of 118 million shares and over 3.5 million options per day. The widespread popularity of SPY is one reason why SPIKES has a real chance of competing with the VIX.
First off, the MIAX is in a position to offer very competitive fees for trading SPIKES. In fact, it was just announced that WEX – a popular high-speed execution platform – will be offering SPIKES trading to its clients. More big players are sure to follow suite given the cost savings involved.
Using SPY options as the underlying product for volatility calculations also has several advantages. The ETF is roughly one-tenth the size of the SPX, so it’s easier to trade for many smaller traders. The result is more liquidity across more strikes. Plus, the bid-ask spreads tend to be very narrow. This all adds up to an even more accurate volatility calculation than what you may see in the VIX.
And yes, SPIKES does use the variance swap calculation method similar to the VIX. Once again, that’s what the industry wants and one of the reasons other competitors (who focus on straddle values) have not gained in popularity.
Moreover, SPIKES uses a proprietary price-dragging method to generate prices in more illiquid options strikes. In other words, it should keep erratic prices from popping up and skewing the overall calculation. This helps the index remain accurate during highly volatile markets.
The settlement process for SPIKES offers a key benefit over VIX settlement as well. While both processes are completely transparent, VIX futures can only be traded on just one exchange. It’s easier for one trade to cause an imbalance during the settlement process when only one exchange is available to work through the imbalance. However, SPY options are traded on 15 exchanges, so imbalances can quickly be arbitraged away.
There is one big difference between SPY and SPX – SPY offers a quarterly dividend. The dividend offering is likely to cause a short-term disparity between implied volatility in SPX options and SPY options. That is, SPIKES and VIX could diverge around the time of the SPY dividend. This could provide some excellent arbitrage opportunities for savvy volatility traders. Ultimately, arbitrage opportunities could lead to even more growth in volatility trading.
SPIKES and VIX are similar products. Their calculations should end up being pretty similar (outside of periods around SPY dividends). Nevertheless, competition in the volatility trading space is a good thing for consumers. There’s absolutely no reason volatility trading can’t support multiple types of products given how popular it has become.
The more viable products there are available, the better it is for the end user. Additionally, arbitrage opportunities should increase as more products hit the market, which is also good for the exchanges. Overall, a successful VIX competitor like SPIKES will be a win-win for the options industry.
