Friday, February 22, 2008

The Rising Popularity of XLF Options

Earlier in the week, I looked at the decreasing volume in VIX options in Interest in VIX Waning? Over the course of my analysis, I attributed some of the decline in VIX options to the launch of QID (and SDS) options back in November.

While the QID and SDS are undoubtedly stealing some market share from the VIX for those looking at leveraged hedging opportunities, a much bigger factor has been the meteoric rise in interest in options for XLF, the financial sector SPDR.

As the graphic below demonstrates, XLF options were not actively traded until July 2007. After a surge in interest in mid-summer, volume dropped off until November, at which time implied volatility and options volume both rose dramatically. By means of comparison, back in June 2007, XLF and VIX options traded in roughly equal numbers, but so far in 2008, XLF options volume has been outpacing VIX options volume by about five to one. Additionally, I find it noteworthy that a there has been a sustained increase in XLF options volume since the beginning of November – the same time that VIX options volume peaked and started to decline.

There are several other features of the XLF implied volatility chart that are worth pointing out. One of which is that implied volatility and options volume have moved in almost perfect lockstep over the past six months. Another point of interest is that XLF implied volatility peaked just as the major indices bottomed in January. A break below the current 35 support level might signal a lessening of put activity in the financial sector and perhaps indicate that the January bottoms are a good bet to hold.


Unknown said...

How is VIX and XLF correlated? Why would XLF options take away interest from VIX?

Bill Luby said...

Hi Fiaz. There is a strong negative correlation between the VIX and the XLF -- not surprising, given that financials are the most heavily weighted sector in the SPX.

From a hedging perspective, instead of buying VIX options and taking a shotgun approach (i.e., across all sectors) to hedging, many investors may find it more efficient to take a the more targeted rifle approach by focusing on hedging the financial sector only. This was presumably done on the assumption that if the markets turned down sharply, it would be the financials that would lead the way down. For this reason, with concerns on where the credit crisis might be leading the markets, I suspect an XLF put became a better buy than a VIX call, at least for some.

All speculation on my part, though...



Unknown said...

fiaz, I don't think it's so much a matter of correlation but of the ways institutional traders might try to hedge broad market (SPX-like) long positions.

The CBOE/CFE promotes VIX futures and options as a one way to hedge (long delta) exposure in bear markets. That's not the only way to use them, but it has had a certain appeal to those who have observed that the VIX often spikes at major market bottoms.

But I think what Bill is suggesting is that the XLF is an alternative hedging vehicle, and the rise in options activity reflects greater use of it for that purpose, thus taking away interest and volume from the VIX.

It certainly has several advantages over the VIX, such as tight, penny-priced markets, and the ability to target a hedge to a specific sector, presumably the one institutional traders are most concerned about hedging. And for 'value' investors looking for a way to bet on a bottom in the financials, the XLF and/or its options could be an attractive product.

It occurs to me that the VIX might have tighter markets and more volume if a VIX ETF were available instead of the VIX futures. (Honestly though, I'm not even sure it would be possible to create a VIX ETF.) I believe a VIX ETF could have greater trading volume than a VIX futures.... as there are more stock traders than futures traders. I suspect ETF-based products such as options on the SDS, QID, XLF, etc. should usually have this kind of edge over futures-based products like the VIX, VXN, and RVX (assuming of course that the underlying ETF product has high volumes).


Bill Luby said...

Well said, Felix. You and I are definitely on the same page.

Anonymous said...

The XLF options I.V.'s are much lower than the VIX options and the skew between the calls and puts are less.

The XLF closed at 27.3 on Feb 25th and the Vix index closed at 23.03. The XLF Mar 27 and 28 calls have a I.V. of 39.6 and 37.1 and the XLF Mar 27 and 28 puts have a I.V. of 32.4 and 34.2. This compares to I.V. levels of 96.9 and 90.9 for the Mar 22.5 & Mar 25 calls and for I.V.'s of 36.3 and 46.7 for the Mar 25 and 22.5 puts. The I.V. numbers are caluclated on the spot VIX and not the VIX futures that the VIX options trade off of. The I.V.'s for the XLF options are calculated on the XLF index.

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