Morningstar is the first to make the leap, launching a new set of volatility indexes that compete directly with CBOE's products. The CBOE indexes have a popular suite of futures and options contracts trading in huge volumes, and dominant mindshare in the industry. But Morningstar's approach could constitute a new competitive threat to the CBOE, or at least give investors a new tool, as they take a completely different approach to calculating volatility.

Briefly put, the CBOE volatility indexes base volatility readings on the spreads on options contracts tied to each index; i.e., the CBOE VIX Volatility Index is based on options on the S&P 500. In contrast, the Morningstar indexes used the combined volatility of the underlying component stocks.

Morningstar Derivatives Strategist Philip Guziec, who was one of the creators of the index series, says in an article on the Morningstar Web site that the inspiration for the indexes came from the fact that there were no "intuitive benchmarks for pricing options."

The main upshot to the differences in methodology is flexibility. CBOE needs a liquid index option to calculate a volatility index. With Morningstar's approach, it could calculate an independent volatility index based on a slice of the market not represented by popular index options. So, for example, Morningstar could calculate volatility index for companies that have significant involvement in the ethanol industry. Or the subprime loan market. Or maybe the top 10 companies supporting U.S. operations in Iraq?

Morningstar's Web site is very interesting in this regard. Using the little box tool in the upper right of the page, users can choose to look at the market by size, Supersector or sector. Then, simply by dragging your mouse over the style box, you can see what the volatility of each segment of the market is. There is even a selection of time periods to choose from, and the designated slice of market can also be narrowed further by selecting a "type" of stock, such as "distressed" or "aggressive growth."

Right now, to take the top-level view, Morningstar breaks down the style box volatility as follows (as of 9:53 a.m. on September 12, 2007):

The company also calculates volatility indexes for the market indexes on which the CBOE indexes are based—the S&P 500, the Nasdaq-100, the Dow Jones Industrial Average and the Russell 2000—and displays their values alongside those of the corresponding CBOE index on their Web site.

The differences are notable. While it's not clear if the direct numbers are comparable, Morningstar shows that the Nasdaq-100 is 44.7% more volatile than the S&P 500; CBOE only shows an 8.8% difference.

One reason may be that the Morningstar indexes are weighted by open interest. Guziec says in an article that this approach is similar to market-cap weighting in stock indexes, but it definitely biases the data in favor of volatility: Options traders are attracted to the most volatile stocks, and those stocks will tend to have the most active interest.

Guziec says one of the most important advantages of the MVI methodology is that someone looking at the implied volatility of an options contract can use the corresponding Morningstar volatility index to determine if the figure is high or low. In an explanation on the Morningstar Web site, Guziec explains the difference by calling the Morningstar VMI an "index of volatility," while most volatility indexes actually are the "volatility of an index." Options contracts on individual stocks are "directly comparable" with their corresponding indexes, Guziec says.

CBOE's indexes won't lose their hold on the market, but these new Morningstar indexes do offer an interesting wrinkle.