Schaeffer's Trading Floor Blog

On the VIX, Credit Spreads, and Demand for Volatility Derivatives

Exploring an interesting angle on volatility derivative order flow

by 4/29/2014 9:05 AM
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The demand for CBOE Volatility Index (VIX) derivatives continues to grow and grow. Existing products continue to see expanding volume and promising new listings like the CBOE Short-Term Volatility Index (VXST) futures and options keep coming down to the pike.

So who's behind all this VIX fun? The answer may shock and amaze you!

…OK, maybe that's extreme. But here's an angle on volatility derivative order flow that I've personally never heard before. It comes via an account of the CBOE Risk Management Conference from Global Capital.

VIX derivative order flow observations

It's pretty timely in that we spent a couple of days last week looking at the degree of inverse correlation between equity returns and VIX and the tradable VIX complex. Traders/investors often wonder why their VIX-related paper isn't exploding while the market is declining.

Those tend to be equity players, at least the ones I'm in contact with.

I had never considered the angle that the biggest players were actually using volatility derivatives to hedge credit spreads. And I should have, because it makes perfect intuitive sense. What is a credit spread, after all, but a measurement of the fear level associated with holding the underlying instrument? As fear spikes, spreads widen. The worry is over a "tail" event. VIX itself moves via much the same dynamic, and often in reaction to the exact same events. And the lion's share of demand lies in hedging against the "tails" … in the VIX's case, that translates into out-of-the-money VIX calls.

Now of course, this doesn't explain the entirety of VIX order flow. There's plenty of pure speculation there, as well as plenty of pure equity holders that use it as a general portfolio hedge, quirks be damned. But it helps make the picture a bit clearer. Next time we hear about one of those gigantic out-of-the-money call buys, we'll try to take a gander at credit spreads and see if something similar is going on.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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