Trading on 'fear': the ASX turns volatility into an asset

Market expectations will now be tracked in real time, writes Gareth Hutchens.

WHEN Lehman Brothers collapsed in 2008, traders watched in horror as the so-called global "fear index" surged 300 per cent within weeks.

Officially known as the S&P 500 VIX index, it measured investors' expectations of US sharemarket volatility and was read as a real-time gauge of investor sentiment.

As global markets unravelled, our fear apparently trebled.

Since the Lehman crash, the VIX index has risen sharply on two other occasions as fear spread through global markets.

But while there is disagreement about whether such an index has much predictive power, it has remained a closely-watched benchmark for investors, economists and financial media.

Now Australian investors have an equivalent index.

The Australian Securities Exchange on Thursday replaced its current end-of-day volatility indicator - the S&P/ASX 200 VIX - with one that tracks traders' expectations in real time.

It says it has done so because demand has been growing from the financial community to trade futures over the VIX.

By turning the VIX into a real-time index, it will allow the ASX to create derivative products for trading and hedging against volatility.

So it will turn "volatility" itself into an asset class.

"Over the past few years of global economic uncertainty, volatility has emerged as an asset class in its own right," ASX deputy chief executive Peter Hiom said.

"As a consequence, we have seen the global development of derivatives products that can hedge, trade and diversify investment portfolios against volatility.

"Appetite for derivative products over the VIX has grown since the launch of the end-of-day VIX index in 2010. The real-time VIX is an important prerequisite for ASX to launch VIX futures, which we are on track to deliver towards the second half of this calendar year."

The index works by reverse-engineering the implied volatility sitting in index options, and is therefore a forward-looking index - it shows how volatile market participants expect the sharemarket to be over the next 30 days.

The more volatile they expect the market to be, the more expensive those options will become and the higher the VIX index value.

It will be of particular interest to fund managers because it will provide them with a new asset class to include in their portfolios - if they believe market volatility is going to increase, a VIX future contract will allow them to make money from that belief, or to hedge against it. The difference between the old end-of-day index and the new real-time index has to do with how it is measured.

The old VIX, which was launched in September 2010, was based on the end-of-day settlement prices of key options. But the new index takes the average of the bid-ask prices for key options that are being used to calculate the index. That's how it can provide a volatility benchmark in real time.

In the past few years, volatility futures and options have been very successful contracts for the Chicago Board Options Exchange, which runs the global benchmark S&P 500 VIX index.