The ultimate fear profiteer

August 11, 2011: 3:38 PM ET

Every day traders play the VIX -- the market's fear index. But the Chicago Board Options Exchange wins whether it's up or down.

FORTUNE -- When traders want to know if the sky is falling, they look to the VIX index. It's Wall Street's greatest fear gauge. Technically the index tracks stock options to gauge the market's expected swings both up and down. But mostly it grabs the attention of investors wondering if stocks are headed for a rout.

The VIX spiked to all time highs in the fall of 2008, then it calmed down as the market steadily recovered, and now it's back to making crazy swings. On Monday, as stocks crashed, the VIX shot up to a two-year high of 48 before falling 27% the next day and rising 13% on Wednesday.

Traders can make fistfuls of money buying and selling options and futures based on the VIX, or the CBOE Volatility Index (VIX). But the ultimate fear profiteer is its owner, the Chicago Board Options Exchange.

Revenue from licensing the VIX to a host of exchange-traded funds, combined with other miscellaneous revenue, jumped 63% to $3 million in CBOE's latest quarter. Companies using the VIX in their own products include giants like the Barclays Capital-owned iPath and the ETF company ProShares. Vanderbilt Professor Robert Whaley, who developed the VIX's inner workings almost 20 years ago, calls it "one of the most successful investments that the CBOE has made."

The VIX story goes back to 1992 when the CBOE, the largest U.S. options exchange, was looking to introduce the first public index to track volatility. It reached out to Whaley, an expert in derivatives then at Duke University. While on sabbatical in France, Whaley started to compile options contracts tracking stocks in the S&P 100 Index and measuring their range of prices.

These forward-looking contracts were a kind of measure of the volatility investors expected to see over the next 30 calendar days. Volatility goes both ways -- you can win when stocks jump but you can lose your shirt when they quickly crash. The VIX is often called the fear gauge because investors looking for protection from falling stocks dominate the S&P 500 Index options market, on which the VIX is now based, says Whaley.

After Whaley finished creating the index, the CBOE's head of research suggested naming its ticker with Whaley's initials -- REW. Whaley laughs at the idea now. Thankfully another stock was already using the ticker, so Whaley picked VIX out of a dozen options.

Whaley now sounds slightly rueful when asked about ownership of the VIX. Even though he created its brains, CBOE retains all the ownership rights, which have likely yielded tens of millions of dollars in license agreements and revenue since it was introduced.

Now the CBOE is taking volatility one step further. A few years ago it started offering options and futures tied to the fear index. "What is the "volatility of volatility"? CBOE asks. Not only can you buy options on the VIX, which itself is made from options, but traders can trade futures on the index. CBOE offers a bevy of other volatility indexes tracking oil, the euro, and other stock indexes like the Russell 2000 and NASDAQ 100.

The VIX has traded between 12 and 29 for much of its history. Its all-time average level is around 19. On Thursday it had plummeted 8% midday to 40 as traders no doubt wondered if the worst of the recent market swoon, and the VIX, was behind them.

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