The Early History of Volatility Indexes

 

When CBOE started trading options in 1973, only calls on individual stock options were listed. Puts followed few months later, but it took until 1983 - another decade until index options were introduced. The leading index at that time was the S&P 100 index - partially because of limited computing power, and easier replication than the broader S&P 500, and S&P 100 options were the most popular index options. 

When the stock market crashed in October of 1987, Robert Whaley was low level finance teacher at Duke and moonlighting as consultant in finance-related lawsuits, including one for CBOE. The exchange was being sued for mishandling operations during the crash and letting options trade at unreasonable prices, and during one of the discussions he proposed that “... it would really be interesting to have an index on volatility.” A volatility index was proposed earlier in an academic paper by Menachem Brenner and Dan Galai, but it was more of a theoretical idea - they wrote that a volatility index can be based either on realized volatility, or implied, and provided no practical details. It fell of Whaley to solve all the issues with implementing a practical and useful volatility index.

In 1992 Whaley spent 4 months on a mini-sabbatical in France with a pile of a hard-drives with options data from CBOE working on volatility index. He writes:

The trouble you have by focusing in on the implied volatility of a single option is that its maturity changes every day. And its relationship with the underlying index level changes every day as it moves around the exercise price of the option. So the key ingredients to developing a sensible index would be to somehow hold the moneyness constant—make it an at-the-money option by interpolating around the index level. And by using options with different maturities, interpolate to get a constant 30 days to maturity.

In January of 1993 CBOE introduced VIX - a volatility index on S&P 100, and started disseminating it in real-time. As the concept of implied volatility, or expected variance is too much for talking-heads VIX caught on the moniker "the fear index"; the values of the index became some sort of a sentiment measure, an indicator how nervous investors are about stock decline. This turns out to be quite correct - while stock implied volatility is an unbiased predictor of future realized volatility, index volatility typically runs at a premium, mostly driven by put buying. 

In the following decade options trading has expanded tremendously, and index options became a major revenue source for CBOE. In 2003 they started thinking about launching VIX derivatives, and revamped VIX index using "model free" methodology: instead of using the Black-Scholes formula, the new VIX was calculated as square root of weighted sum of all options. I have blogged about this change, and intuitive meaning behind it.  The underlying options complex for the new VIX was changed to now more liquid S&P 500 options, and the old index was renamed VXO.

Now Whaley is highly acclaimed for his contributions to volatility, and works as a professor at Vanderbilt. 

I follow that number each and every day. I mean, it’s as meaningful to me as looking at the level of the dollar or the SPX, because it’s telling me how anxious people are about the next 30 days.

In the following posts I will write about volatility indexes on different asset classes, including recently introduced cryptocurrency implied volatility indexes. If you are interested in trading cryptocurrency derivatives I recommend Deribit- the most liquid crypto derivatives exchange operated by veteran options traders. They take all security and operational risks quite seriously and the platform is exceptionally robust.