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VIX futures are a form of investing based on the volatility of the options market. That means somebody investing in VIX futures is trying to guess the degree of overall fluctuation of the prices people pay when themselves trying to predict the price movement of the stock market. While the process itself is straightforward, investing in this way is effectively a derivative of a derivative. Making the right forecast and valuing an investment therefore carry an additional degree of complexity because there are more variable factors.
Ultimately, VIX futures link back to index options. These are agreements between two traders that boil down to a two-part deal. First, trader A pays a flat fee to trader B up front and predicts whether the stock market index as a whole will be above or below a particular figure on a set future date. On that set date, if trader A predicted correctly, trader B pays a varying amount depending on how much higher or lower the index was than the agreed figure; if trader A predicted incorrectly, nothing happens.
This agreement, known as an index option, is a tradable asset in its own right, because trader A has the right to sell on his interest in the deal to another trader before the completion date. For example, he may feel his prediction is now looking likely to be incorrect and want to get a small amount of money for certain; the person buying the position may believe the prediction will in fact prove correct and thus think there is a profit to be made. The index options are thus traded in the same way as stocks themselves, complete with a trading market and market prices.
The Chicago Board Options Exchange keeps track of the market prices for index options traded in this way. It also keeps track of the relationship between the price a trader pays for an index option and the predicted stock market price that forms the basis of the option. Using this information it produces a volatility index, with the ticker symbol VIX, that combines the activities of all investors trading in index options based on the Standard & Poor 500 stock index. This volatility index is effectively the combined prediction of all index options traders about how widely the S&P 500 index will vary over the next 30 says. It's important to note this isn't a prediction about whether it will rise or fall, but rather how widely the index will move back and forth.
This has led to a separate product, VIX futures. These work in the same way as stock index options, but rather than tracking a stock index, they track the volatility index. The two traders making an agreement involving VIX futures are thus trying to predict the volatility index figure for a set future date. As with stock index options, VIX futures can be traded in their own right.
The way VIX futures works means they are something of a double derivative. The VIX futures derive their value from the level of movement of the market for S&P 500 stock index options, which themselves derive their value from the movement of the stocks covered by the S&P 500. This double derivative effect means that objectively assessing the value of VIX futures, whether for accounting purposes or merely to see if a particular deal is worthwhile, is a particularly complicated process.
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