Up until last February, the Cboe’s VIX (S&P 500 Volatility Index) was the only market volatility index which could be traded through derivative products. The index itself is not tradeable, but VIX futures, options on those futures, and VIX-related ETFs are all widely popular products. While the usage of these products varied based on the user, the one thing they have in common is using the VIX as the underlying instrument.
However, in February, the SPIKES index launched on the MIAX exchange – a collaboration between T3 Indexes and the MIAX itself. SPIKES is similar to the VIX in that it measures market volatility using options on the S&P 500. However, the VIX uses SPX options for pricing purposes (the S&P 500 index itself), while SPIKES relies on SPDR S&P 500 ETF (SPY) options for its calculations.
So how can SPIKES compete against the 500-pound VIX gorilla? In order to attract customers, SPIKES offers significantly lower fees than VIX. SPY also tends to be more liquid, with more active strikes than the SPX. This is particularly important in times of high volatility, where price accuracy can be an issue if liquidity dries up. (SPIKES also uses a proprietary price-dragging method to keep accurate prices in place if things get too crazy.)
In the coming months, MIAX will likely launch SPIKES futures to go along with the existing options market. The addition of futures should allow SPIKES to compete on an equal basis with the VIX. It also means SPIKES-based ETFs will be a possibility down the road.
But what about the performance? While the SPX and SPY are very similar instruments, they aren’t identical. In fact, the big difference comes from the SPY offering a quarterly dividend (which isn’t the case with SPX). So then, historically, how do the VIX and SPIKES compare?
A new white paper by Dr. Peter Carr delves into this issue. First off, Peter Carr is perhaps the most respected name in options and volatility research. He is to this field what Warren Buffett is to value investing.
Dr. Carr is chair of the Department of Finance and Risk Engineering at NYU. He was previously managing director of market modeling at Morgan Stanley. He’s also won just about every accolade available in the field of financial engineering and risk modeling. All that is to say, you can bet any paper by Peter Carr is going to be immediately taken as if written on stone tablets.
So what did Dr. Carr discover in his research?
First and foremost, in the period from 2005 to 2018, the difference between SPIKES and VIX was negligible on average. In other words, from a medium to long-term view, you could have used the two indexes nearly interchangeably.
In the short-term, there were some noticeable differences around SPY’s quarterly dividend, as you’d expect. Most of this different was due to what’s called the early exercise premium, a phenomenon exclusive to American-style (early exercisable options). In a nutshell, the ability for SPY options holders to exercise their options early (to collect a dividend once a quarter) can cause a higher level of volatility in the options around those periods.
There are few points to consider. The early exercise premium is influenced by both dividends and interest rates, although interest rate contributions to options pricing are usually minor. Furthermore, the impact of the early exercise premium is probably not very impactful to out-of-the-money options, from which both the VIX and SPIKES are largely priced.
Here’s the bottom line. If we assume constant interest rates and dividend yields the difference between SPIKES and VIX due to the early exercise premium is generally trivial. When there is uncertainty surrounding these variables (generally in the short-term) there can be an additional volatility premium in SPIKES.
To put it simply, there may be a short-term period where SPIKES is higher than VIX when dividends are a factor. This is due to the extra volatility of the early exercise premium. How big that gap can get is something that will certainly be researched by interested parties. In the meantime, savvy investors may be able to take advantage of this gap to make money when it occurs.