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Sasha Maksymenko

A Ukrainian anti-government protester in Kiev's Maidan Square. the protest and takeover of the Crimea by Russia has caused volatility in the global markets.

CBOE's 'Fear Index' guages market risk with Ukraine crisis escalating

by Annabelle Ju
Mar 14, 2014

The Chicago Board Options Exchange’s “Fear Index” is helping investors make sense of world events, like the Ukrainian crisis.

And now,  CBOE Holdings Inc., the exchange’s parent is planning to expand trading of the derivative—properly called the  “Volatility Index” (VIX)—and adding similar new products to measure market risk.

“Generally when there is major uncertainty in the market – as in the first day of  the Russian-Ukraine event – CBOE Volatility Index futures and options are quite active,” said CBOE spokeswoman Gail Osten. “Generally higher trading volume.”

The Volatility Index (VIX) is exclusively owned by CBOE and measures short-term risk, going forward, based on the S&P 500 index option prices. The VIX surges in times of political and economic turmoil, as the stock market becomes unstable and investors flee toward options and futures as a hedge.

CBOE’s Volatility Index is unique compared with other indices because it provides forward-looking measurement of risk associated with markets—over a 30-day period—as opposed to other indices that consider market performance from the previous day, week, month or year.

Ten-year-old VIX has proved to be a boon for CBOE’s transaction volume—especially since the crisis in Ukraine intensified in February with protests against President Viktor Yanukovych becoming increasingly violent. The situation boiled over March 1 when troops with unmarked uniforms, but reportedly under Russian command, took over Ukraine’s Crimean peninsula, on the Black Sea.

Last month, mounting investor fears over global economic impacts of the crisis pushed VIX futures’ average daily trading volume upward to 216,797 contracts, a 35 percent increase from February 2013. Meanwhile, the VIX options trading volume was a whopping 16.3 million contracts last month, a 55 percent increase from the year-ago period.

CBOE announced early March that these trading volumes were record-shattering.

“There’s a tremendous thirst for the knowledge of VIX, which grows stronger every year,” said Edward Tilly, CEO of CBOE in a March 4 conference call. “VIX trading created a whole new market place and an asset class.”

Even during “prolonged periods of low volatility” in 2013, Tilly said the VIX experienced double-digit increases.

In the 2013 fiscal year, VIX options traded 567,000 contracts per day on average, another record and a 28 percent increase from 2012. VIX futures traded 159,000 contracts per day on average last year, a 67 percent hike from 2012.

According to Michael Gorham, director at Illinois Institute of Technology’s Stuart Center for Financial Markets, it’s riskier to trade futures than stocks. But he doesn’t see a reason why anyone should feel discouraged from getting involved with VIX.

“In a world where most derivatives products fail, this is a spectacularly successful product,” Gorham said.

CBOE provides traders with information on the general volatility of stocks in the near future through VIX, and that’s helpful because they want to make successful trades. Also, VIX captures major events around the world, like the Ukrainian protests and Russian invasion of Crimea, because the VIX rises and falls in accordance with them.

The sharp volume increase for VIX in recent months indicates that people are becoming more interested in stock volatility. But Tilly thinks there’s still more work to be done.

“We believe we are still in the early stages of growing VIX domestically and that we have hardly begun to scratch the surface internationally,” Tilly said in an earnings conference call last month.

CBOE plans on expanding its volatility trading in 2014 through three main initiatives: enhanced investor education, allowing easier investor access to the volatility market and new volatility products.

The company is launching an updated website with more information and user enhancement: the website will be mobile-friendly and provide more navigation options to its users. Furthermore, CBOE is creating a mobile and tablet application for investor education on options and volatility.

The investor education aspect has another initiative: an enhanced Options Institute curriculum for 2014 for both in-classroom and virtual learning. The curriculum will teach investors about VIX options and futures, and SPX trading.

In order to widen access to the volatility market, CBOE has been expanding its VIX trading hours.

CBOE added five hours and 45 minutes of trading time to the VIX futures market in the 2013 fourth quarter.

“The extended trading day represents the demand from U.S. customers for additional trading time,” Tilly said, “while enabling European-based customers to access VIX futures during their local trading hours.”

It is essential for CBOE to accommodate the ever-increasing trading demand and volume because it’s the last remaining exchange standing on its own. Other exchanges were acquired by giants like the IntercontinentalExchange Inc. and CBOE needs to maintain its competitiveness through these expansions.

Thanks to these adjustments, VIX futures trading starts at 2:00 a.m. CST, or 8:00 a.m. Greenwich Mean Time when trading begins in London.

According to Tilly, there were notable surges in trading volumes in late January and early February – a period of relatively high volatility, as hundreds of thousands joined street protests against Ukrainian President Yanukovych  – and, so far, 8 percent of VIX futures trading occurs at non-regular hours.

“We’re pleased with the volume we see thus far during non-U.S. trading hours,” he said.

CBOE plans on further increasing its futures trading hours to “nearly 24 hours” to tailor to the Asian markets and eventually including VIX and SPX options to this initiative this year.

Just last month, CBOE launched a new volatility product, VXST. VXST is a short-term VIX Index and, like VIX, is based on option prices on SPX. But instead of the monthly options that VIX uses, VXST is calculated from weekly SPX options.

Aside from the VIX, CBOE is expanding its IT infrastructure this year. Tilly said the exchange is focusing on the expansion of IT hardware, capitalized software and data centers in our headquarters.

CBOE Chief Financial Officer Alan Dean said the capital expenditure in 2014 includes investing in regulatory surveillance software.

This comes at a time CBOE is tightening its trading regulations. Earlier this month, it introduced several requirements for its trading permit holders, like providing an annual report on regulatory practices, to prevent fraud. That was a response to the fine it received from the U.S. Securities and Exchange Commission in June 2013 for insufficient monitoring of its members.

Recently, CBOE renewed its partnership with Standard & Poor’s, extending its exclusive trade agreement on the S&P 500 Index to 2032. It also increased its weekly contract accessibility, allowing investors to customize the options contracts. Furthermore, it plans on expanding its trading hours to make trading available 24 hours a day to accommodate the Asian markets.

There are three main areas in which CBOE is taking on strategic initiatives for 2014: leveraging and developing proprietary products, optimizing revenue for commoditized products and expanding the customer base for its services.

“We’ve been a public company now for almost 10 years. We started at 17 cents per share and most recently [we were at] 50 cents per share dividend,” Tilly said of increasing CBOE’s profitability for shareholders. “There’s no reason why more cash can’t be given back to shareholders in dividends and purchases.”

Tilly said CBOE “remains focused on our core mission to generate value for investors” with high profit margins and growth rates.

“Our business generates a significant amount of cash,” he said. “We are committed to returning excess capital to stockholders.”

Despite all this, research analyst Richard Repetto of Sandler O’Neill & Partners LP evaluated CBOE as “hold” on Bloomberg.

“This is the highest multiple valuation of any exchange,” Repetto said, saying this is a normal outlook for an exchange as large as CBOE.

Regardless, Tilly is excited about further expansions in volatility trading coming this year.

“We will continue to sow the seeds for our company’s future growth,” he said.