The Market for Volatility Trading

Abstract

Volatility/variance has become an asset class in its own right. In late 1990s, Wall Street firms started trading variance swaps, forward contracts written on the realized variance. These swaps are now the preferred route for many hedge fund managers and proprietary traders to make bets on market volatility. The exchange-listed volatility products started with the Chicago Board Options Exchange (CBOE) volatility index (VIX) futures on 26 March 2004, followed by the S&P 500 three-month variance futures on 18 May 2004 and VIX option on 24 February 2006. Currently, there are six kinds of volatility futures and three kinds of volatility options traded on the CBOE. There are three kinds of volatility futures traded on the Eurex. They are derivative contracts written on either the volatility index or realized variance. To establish an intuition on the market size, we looked at the data provided by the CBOE. For example, on 11 December 2008, The CBOE volatility index, VIX level was 55.78. The open interest of VIX futures was 27,287 contracts, which corrsponds to a market value of 1.5 billion US dollars. The open interest of VIX option was 18,720,920 contracts, which corresponds to a market value of 5.9 billion US dollars. The S&P 500 three-month variance futures is much less liquid. Its trading volume was only 78 contracts. In this paper, I will present the historical development of the market for volatility trading, and review classical literature on pricing variance swap, such as Carr and Madan (1998), and Demeterfi, Derman, Kamal and Zou (1999). I will also discuss the recent development on studying CBOE-listed volatility derivatives such as VIX futures and options, and the S&P 500 variance futures, including Zhang and Zhu (2006), Brenner, Shu and Zhang (2006), Zhu and Zhang (2007), Lin (2007), Sepp (2008ab), and Zhang and Huang (2009).