What is the CBOE Russell 2000® Volatility Index?

Posted on Wednesday, May 8th, 2019 MarketBeat Staff

Summary - The Russell 2000 volatility index (RVX) was created by the Chicago Board Options Exchange (CBOE) as a way to represent the stock market's expectation of forward-looking volatility over a time period of 30 days. The index is derived from price inputs from the Russell 2000 index options (known as RUT options). Investors, analysts, and portfolio managers can look at the RVX as a way to gauge investor fear and stress in an attempt to measure market risk.

The RVX measures the performance of the 2,000 smallest stocks out of the top 3,000 stocks in the United States. The index is weighted by market capitalization. In the case of the Russell 2000, it is regarded as the small-cap index because it tracks companies with a market cap that is loosely defined as being between $300 million and $2 billion.  

Trading the RVX is done in the form of a futures contract. Investors can buy call options or sell put options depending on their perception of future price movement. RVX futures can be an effective way for investors to hedge equity returns and to diversify their portfolios. In many cases, investors choose not to trade the RVX, but rather to trade the Russell 2000 index through the purchase of RUT options.

The RVX is one of many volatility futures that can be traded. The VIX is one of the most commonly cited in the financial media. This is the index that tracks volatility in the S&P 500. The VIX is the index that is being referred to when the “Fear Index” is referenced. The NASDAQ volatility future operates under the ticker symbol VXN. Because the RVX is focused on small-cap stocks, it will generally show a higher number than the VIX, which reflects the underlying nature of these stocks, which tend to be growth stocks.

As you would expect when investors have concern over a stock’s performance, the volatility index will increase. As an illustration of this, in 2007, the VNX rose to its highest level at the height of the financial crisis. Conversely, when investors are confident about a stock’s performance (which can be independent of price direction), the VNX will remain at a constant, low level. That has been the case for the last several years as the market has been on a historic bull run. However, as of late April 2019, the VNX has shown a spike and sits above 4 – a level not seen in over five years.

Introduction

Fear is one of the biggest motivators for human behavior. In investing, fear equates with risk. One of the ways investors use technical analysis to manage risk and to gauge how other investors feel about particular security is through a volatility index. The most well-known volatility index is the VIX which tracks investor sentiment surrounding short-term price movement in the underlying S&P 500 stocks. The VIX can be used as a general barometer for any index. However, for investors who want to have a little more precision, they can choose to use an index that is specific to the index they are trading.

Small cap investors frequently look at the Russell 2000. The volatility index for the Russell 2000 is the Russell 2000 volatility index which is traded on the Chicago Board Options Exchange (CBOE). In this article, we’ll take a look at this index and show you how it relates to RUT options. We’ll also provide an overview of the Russell 2000 and its significance to investors. We’ll conclude with a review of what volatility means and a brief discussion of how to analyze volatility indexes for potential trading opportunities.

What is the CBOE Russell 2000® Volatility Index?

The Chicago Board Options Exchange (CBOE) is the largest exchange for options in the United States. The exchange houses the Russell 2000 volatility index. This index is an indicator of the short-term expectation of volatility in the stock market as it relates to option prices for the Russell 2000 Index. Short-term is defined as a period of 30 days. This index operates under the ticker symbol RVX.

Trading the RVX through the CBOE is done through the purchase of a futures contract. An RVX contract follows these specific criteria:

  1. The expiration date for the contract is the Wednesday that is 30 days before the third Friday of the month. This occurs in the month following the month the option expires.
  2. The option can continue to trade until the Tuesday prior to price expiration. In the event of a holiday, that date becomes the trading day immediately preceding the expiration date.
  3. If an option is purchased within nine months of its expiration, it must be paid in full.
  4. The contract, like the index, trades on Central Standard Time (CST).

To help understand the significance of the CBOE Russell 2000 volatility index, it’s important to define the Russell 2000 Index.

What is the Russell 2000 Index?

The Russell 2000 Index tracks the 2,000 smallest stocks out of the largest 3,000 stocks in the United States. For a stock to be tracked by the index, it must trade on a major stock exchange (NYSE, NASDAQ or AMEX). The Russell 2000 is just one of several Russell indexes. It is also known as the "small cap" index because the stocks it tracks have stocks that fit the small cap market capitalization definition. While this definition can vary depending on the financial institution or brokerage, it is generally considered to mean a company that has a market cap between $300 million and $2 billion. The opposite of the Russell 2000 index is the Russell 1000 index. This is known as the large-cap index because it tracks the 1,000 largest stocks out of the largest 3,000 stocks in the United States.

There are many different mutual funds and ETFs that are offshoots of the Russell 2000. Funds such as the RVX Emerging Markets Equity Opportunity Fund are ideal for investors who want exposure to a specific market.

The Russell 2000 index trades on the CBOE under the ticker symbol RUT. Like the RVX (which means you’re trading the index), trading the RUT through the CBOE is also done with a futures contract. RUT options are benchmarked to the RVX, rather than the VIX.

  1. Generally speaking, options can only be exercised on their expiration date. This is set as the third Friday of the month of expiration.
  2. The option can trade until the close of business the Thursday prior.
  3. Strike prices are initially listed with a minimum interval of 2.5 points. This increases to 5 points if the strike price exceeds 200.
  4. An option that is purchased within 9 months of expiration must be paid in full.
  5. RUT options feature transparent prices and quotes.
  6. Trading is done from 8:30 a.m. – 3:15 p.m. Central Standard Time (CST).

Understanding volatility

Volatility plays a key role in understanding the significance behind price movement as it relates to investor sentiment. The definition of volatility is “a measure of the variance of returns over a period of time”. Volatility has a historical correlation with investor fear. For example in times of economic growth, the market generally trends up. Because investors are optimistic, volatility is typically low. In contrast, when the market is going down, fear increases and volatility will increase. Volatility is found in securities of all types, and for equity markets in particular.

Volatility can be measured on an individual stock basis or it can be expanded to view entire sectors of the market (i.e. industrials, financial, technology) or by individual markets (which is the case of the Russell 2000).

When it comes to investing, volatility is expressed in terms of implied volatility or realized volatility.

Implied volatility– this is the market’s assessment of future volatility.

Realized volatility– this reflects volatility that has already occurred.

Although it’s beyond the scope of this article to go into the detailed calculation of volatility, two of the general principals are to first calculate a security’s daily return and then second to calculate the standard deviation to determine its daily volatility. Standard deviation refers to the measure of variance from the mean of a data set.

Once the daily volatility of a security is calculated, investors can calculate its annualized volatility, which is a measure of the variance of returns over the period of a year.

Having a standard, quantitative measurement of volatility allows investors to compare the price moves and associated risk for different stocks, markets, or sectors.

How to trade volatility

The way to trade volatility is by the purchase of put options or call options. The investment strategy used is to:

  1. Identify the trend for the underlying security. This is important because a security may be rising in price, but the RVX may be remaining very steady. Some traders look for at least a two-day sell-off or increase as a trading target.
  2. Identify areas where the stock is pulling back, and use them as buy signals, particularly if they correspond with a high in the RVX.
  3. Identify areas where the stock is breaking out, and use them as sell signals, particularly if they correspond with a low in the RVX.

Limitations of trading the RVX

One of the limitations of trading the RVX is that RUT options, like all options that are settled in cash, stop trading the Thursday before their expiration date. However, the expiration date is not until, technically, the Saturday morning that follows the third Friday of the expiration month. This is significant because although the option stops trading on Thursday, the final settlement price is not calculated until after overnight trading from Europe and the Asia-Pacific region. Also, RUT options are not settled based on the price of the underlying stocks but rather based on a separate index called the RUT Flex Opening Exercise Settlement (RLS). All of this is to say that it is possible that the RLS value for a particular day may be higher/lower than the RUT option.

The final word on the CBOE Russell 2000® volatility index

The CBOE Russell 2000 volatility index is essentially the VIX for the Russell 2000 Index. It is considered a key measure of stock market expectations for short-term (30 day) volatility and is conveyed by the option prices of the Russell 2000 stock index (RUT). RVX is quoted as a percentage, just like the standard deviation of a rate of return (for example, 22.24).

Historically, the RVX and the RUT options that they track to move in opposite directions. That is when volatility is high RUT options are declining in value. Likewise, when volatility is low, RUT options tend to be rising in price.

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