The article below is provided by Michael McCarty. Mr. McCarty is the founding member and chief strategist of Differential Research.

As trading volume grows for volatility index and volatility index security futures outside of the popular CBOE Volatility Index® (VIX®) futures, investors will increasingly be able to hedge specific ¬portfolio risks. While a pure equity portfolio highly correlated with the S&P 500 Index (S&P 500) may be content hedging with VIX futures, a technology portfolio for example may find the CBOE Nasdaq-100 Volatility Index (VXN) future a better vehicle. Likewise an emerging market portfolio may find CBOE Emerging Markets ETF Volatility Index (VXEEM) security future more negatively correlated and therefore a better hedge.

As these markets continue to develop, different assets’ implied volatilities will increasingly present arbitrage opportunities. For example, as Apple Computer is highly weighted in the NASDAQ 100 Index (NDQ), its implied volatility is a significant factor in the value of the VXN index and the price of VXN futures. Consequently, there may be opportunities to trade the difference between the price of VIX and VXN futures.

While we will look at the differences between futures prices shortly, given the longer history for the calculated indexes’ values, we will look at the historical relationships first for a slightly longer term perspective. However, first a quick refresher on the differences between broad based volatility indexes, exchange-traded fund (ETF) based volatility indexes and futures and security futures. First the indexes are calculated using the mid-point between the bid and ask price of two series of CBOE-listed options for the underlying index, except at the moment of expiration when only one series is used. The two series are weighted to arrive at a thirty-day average term. At expiration the opening prices are used. The future value therefore is essentially the market’s estimate of what the value will be at expiration, while the index is an estimate of what the value would be if expiration occurred at that moment. At expiration the two values converge, although they will likely differ given the difference between actual trade prices and mid-points.

First we will look at the period with data available for all of the broad based volatility indexes and ETF based volatility indexes beginning April 13, 2011. For comparison purposes we will use the VIX index as our reference, and look at the spreads in relation to the VIX index.

Sources: CFE, Yahoo Finance, Differential Research, LLC

From the graph above we can see that each index demonstrates unique behavior, confirming our thesis of potential arbitrage opportunities.

Sources: CFE, Yahoo Finance, Differential Research, LLC

As would be expected the difference between the VIX and VXN indexes show the least variation, while the CBOE Crude Oil ETF Volatility Index (OVX) has demonstrated the greatest range versus the VIX Index for the period.

Sources: CFE, Yahoo Finance, Differential Research, LLC

Looking at the past year shows similar results.

Sources: CFE, Yahoo Finance, Differential Research, LLC

The unique characteristics of the different indexes are more apparent when viewed up-close.

Sources: CFE, Yahoo Finance, Differential Research, LLC

Once again it is clear that oil ETF volatility as represented by the OVX index has demonstrated the greatest range when compared to the VIX index.

Sources: CFE, Yahoo Finance, Differential Research, LLC

Sources: CFE, Differential Research, LLC

Turning our gaze to the October volatility index futures and security futures that recently expired, we see that daily settlement highs and lows were not set simultaneously.

Sources: CFE, Differential Research, LLC

While the price charts visually suggest a high degree of correlation for the group, the OV security future declined the least.

Sources: CFE, Differential Research, LLC

While the existence of an overall general trend would seem to confirm the thesis of “risk-on/risk-off”, the unique patterns suggest that perceptions of risk are more nuanced providing an intellectual underpinning for the pursuit of inter-volatility market arbitrage opportunities.

Sources: CFE, Differential Research, LLC

Sources: CFE, Differential Research, LLC

And while futures and indexes differ, we can see that the October futures reflect some of the same differences and similarities as the underlying indexes. Specifically the spread between the October OV security futures and the October VIX future rose in general over the period.

Sources: CFE, Differential Research, LLC

Looking at each future individually, we see the October VIX index future fell for much of its life. As we have witnessed over the past several months open interest and trading volume in the VIX future increased steadily while the second serial future peaked as it ascended to the front month and fell through expiration.

Sources: CFE, Differential Research, LLC

The October VXN future in turn saw volume and open interest climb and fall before and after the release of Apple Computer’s earnings.

Sources: CFE, Differential Research, LLC

The October OV security future notably maintained its value for most of its term.

Sources: CFE, Differential Research, LLC

Sources: CFE, Differential Research, LLC

Sources: CFE, Differential Research, LLC

Finally, one important consideration for anyone considering establishing an arbitrage position in volatility futures is contract size. For VIX and VXN futures the multiplier is $1,000 while the multiplier for volatility index security futures is $100.

data sources: CFE, Trade-Alert LLC, Yahoo Finance and Differential Research LLC

The risk of loss in trading commodity futures and options is substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.