Exactly. You're talking about a variance swap. The challenge is, no market can exist for a contract unless the exchange can convince sellers that they can effectively duplicate/hedge the contract using other assets. You can't make this work with speculators on both sides. Index variance swaps *can* be duplicated/hedged using strips of underlying options, re-weighted as the underlying moves. But when you're talking about random stocks, yes it can be done, but with relatively few option strikes (sometimes spaced apart 10-20% in value)... the costs will be very high. I'd expect a huge ask/bid spread for any individual stock.
It would allready be priced into it (well approximately about of it) as you would in effect be trading forward vol. My mistake for not seeing it immediately ...
i dont know if retail would use it but I like to know where the atm vol is. otc fx options and rate swaptions are quoted this way and look at delta instead of strike.
Just so that I am being clear, each equity option for each expiration month would have one of these products. So IBM continuous Mar19 ATM forward vola, GE continuous Apr17 ATM Forward vola, etc. This is not a VIX product on the average summation of the first two months....
They hold no more complication than buying/selling an ATM straddle/strangle, in fact it might be easier to replicate and therefore hedge. Since the contract has no exposure to delta or gamma, I believe the other side would have no delta or gamma exposure as well. As far as I can tell, there is no need to replicate with the underlying. We are simply making a bet on the level of volatility (purely the extrinsic value of the continuous ATM forward straddle) and we settle in cash. Since there is no delta or gamma risk they should be cheaper than their vanilla counterpart, I think...It would be easy to keep in line by arbs against the extrinsic value of the vanillas. Therefore they are not only European, these cannot be exercised into the underlying at all by definition. You don't have to hold them to expiration. You can buy and sell them on the open market as you please.
Maybe you're right - I would have to think about it more. If the introduction of the new product does not change the IVs/price of the existing individual options of the underlying, then I don't know how it could already be priced in. If there's a discrepancy between the new product's price and the individual options prices, then there could be a play on the difference in implied volatility. But again I haven't thought it through.
Hmm, I don't know. I know there are instruments based on weather, real estate numbers, jobless numbers, etc, etc... so surely, you can create random instruments on any "bet". However, note that VIX futures exist precisely because the settled current value is calculated as a variance swap, using larges strip of option strikes to generate the final number. http://cfe.cboe.com/education/vixprimer/About.aspx When you say it's easy to keep in line by arbs against the extrinsic value of the vanillas... which vanillas? If you're looking to offload the costs behind delta/gamma-hedging as the underlying moves away from the current ATM level, how much do you pay the other side to do the same?
Ok, look, let me back up. An option has a price. That price can be broken down into two components: the intrinsic price, and the extrinsic price. The intrinsic value of an option is derived from how much in the money it is. The extrinsic value of an option is what makes option trading interesting as options, it is how much we value the capacity of the underlying to move a certain amount. All I want is a pure product of the second, the extrinsic price. So you see, I am not inventing some product from left field out of nowhere. I am simply creating a logical product and choosing to have exposure only to that part of the option. You are confusing VIX with this product. They address to very different things. One is a very simple product targeted at isolating a very special strike of an expiration, the ATM forward "strike", and it's volatility. The VIX is all over the place in months and strikes, and is a very complicated product, that in fact has all the flaws that you describe in that it is not a natural product. Professional option traders always know what the "little strangle" is. That is the one that is closest in pure volatility to the ATM forward straddle, and if there are dollar-wide strikes, they trade very close to the ATM forward straddle in volatility terms when you remove any underlying (intrinsic) effects.
Obvious statement of the day here: to have a contract succeed, you need to have liquidity. VIX products exist because whenever a buyer comes into the market, a seller can take the other side of the trade without taking ANY risk. If I'm a VIX future market maker, whenever I have a short position in the VIX future, I can hedge my risk away completely by going into the (highly liquid) option market and buying a static array of options. That's the point: even though no one was trading VIX the day before it was created, it could be traded the next day because a highly liquid arb equivalent instrument existed. Where's the liquidity in what you described? If no market maker really wants to be short this instrument at the moment a large speculator wants to go long, then how's it going to trade, except with a huge ask/bid spread? I realize the atm strangle has an IV close to what you're looking for. I realize you can easily define an instrument this way. But so what? If I sell you this ATM vol hedge, now what do I do? Go buy the ATM strangle? And what happens when the underlying moves (exactly the situation you wanted to avoid)? Buy new strangles? You could also define an instrument on the number of people born in a hospital on each given day. But how do you get liquidity for it?
You can hedge it with the little ATM strangle. What do MMs do when they sell ATM straddles or strangles that are even harder to hedge and manage than a pure vola play? Every problem this contract could have, the ATM straddle/strangle has 5x over already because they have delta, gamma as well as vola exposure. My contract is easier to hedge not harder.