Partner & Managing Director, New York
There has been a lot of buzz in the press and in the blogosphere recently regarding volatile swings in the CBOE Volatility Index (VIX) and volatility-related financial products. Some sources say regulatory investigations have begun to determine whether these financial products have been manipulated, or if the VIX index itself was tampered with.
There is a lot of complexity in the volatility trading arena, and as you listen to such news and read these stories is it important to understand that "The VIX" can refer to many different things. Here are a few basic and important things to know about the VIX.
The VIX Index
This is the chart that gets shown on the news, and what you will see if you type "^VIX" into your web browser. It is also known as the spot or "cash" value of the VIX Index, calculated every 15 seconds by the CBOE. It is generally thought of as being an estimate of the expected level of volatility of the S&P 500 in the upcoming 30 days. However, this is purely a hypothetical number derived by a formulaic calculation, rather than by trades in a "VIX" contract. It is calculated using the midpoint of real-time bid and ask quotes (not trades) on S&P 500 Index options.
You can't "buy" the VIX index in the same way that it is not possible to buy an index "ticker" like the Dow Jones Industrial Average (DJIA). While it would be possible for a DJIA investor to buy the 30 stocks that comprise the DJIA, attempting to replicate the VIX by buying a portfolio of S&P 500 options would be more complicated, imprecise, and require very frequent rebalancing.
S&P 500 Index Options
The inputs in the aforementioned VIX calculation are CBOE put and call instruments which reference the S&P 500 index. As perceived volatility increases, the prices of these options generally increase, and so does the calculated VIX index.
Regulated VIX futures contracts also trade on the CBOE. VIX futures are like forward contracts on "cash" VIX (which itself measures volatility over the next 30 days). Daily futures settlement prices are based on the last bid and offer for the futures contract before the close, and this closing value is used for daily mark-to-market and position margining purposes. However, when a VIX futures contract expires, and financial settlement occurs, there is a different process for determining this terminal value for the futures contracts. Rather than use bids, offers, and trades for the same VIX futures, the CBOE runs a special auction procedure for S&P 500 Index options that are 30 days from expiry.1
Observers have commented about how differently the S&P 500 Index options trade in this auction. Some point to how the "cash VIX" might differ from the VIX futures settlement price. Others have made allegations that, for these reasons and more, the auction process used to calculate the final settlement price is vulnerable to manipulation.
Cash VIX vs. VIX Derivatives Prices
The levels of "cash VIX" and the final futures settlement can differ because they are calculated differently. Simply put, one uses a midpoint of bids and asks and the other uses actual traded prices.
"Only rarely will traded prices lean towards the midpoint of the bid/ask spread," the CBOE says in its VIX Index FAQs. "As a result, the settlement value calculated for expiring VIX derivatives will tend to lean closer to either the bid or the ask and this value will typically deviate from the intraday (or spot) value calculated for the VIX Index."2
Also, varying levels of participation and inconsistency in the specific options used to calculate the "cash VIX" vs. the settlement auction VIX can also explain differences.
Retail VIX Products
There are various VIX-related ETFs and ETNs available. There are products that track, products that short, and also products that add leverage. These ETFs and ETNs generally use the CBOE VIX Futures contracts to replicate or hedge their exposure. In a simple sense, they are simply "along for the ride" with the first-order VIX futures and derivatives they in-turn reference. Large and sudden moves in the price of VIX futures can force these products to unwind their positions, often exacerbating their losses as market liquidity can become compromised in rapidly-swinging markets.
It is the specific mechanics of these products and their relationship to the VIX or VIX derivatives that needs to be understood when examining how they performed over turbulent periods like last week.
1Special Opening Quotation (SOQ) using opening prices from CBOE's Hybrid Opening System. See CBOE Volatility Index FAQs at cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index/vix-faqs#1