The popular CBOE SPX Volatility Index (VIX 22.93% -0.43) is down again today on the market’s move higher. We have warned and attempted to inform our customers about some of the risks and unique characteristics of the VIX in prior blog entries. Here is one more.
Each day, the VIX derives its value from the interpolated implied volatility surface of the midpoint of 30-day options in the SPX. The VIX index settles its options on the Wednesday morning that falls 30 days prior to the actual expiration of SPX options. This is the only day that the VIX is the actual 30-day measure of LAST TRADED implied vol. Every other day is a market estimation of an interpolation.
Because of the nature of the settlement, typically there is huge volume in the SPX options on the expiration morning of the VIX options, this is called the SPX carpet bomb, where VIX participants buy or sell every out-of-the-money strike in SPX to replicate the exposure to volatility in SPX that their expiring VIX contracts provided. This carpet bomb can produce huge swings in the VIX calculation from the prior day’s closing estimation of the index. The bid-ask width of SPX options in VIX index points can vary but is typically around 3 points.
This means if the settlement of the VIX occurs predominately on the bid side of the SPX options because of carpet bombing sellers in the SPX, the VIX could move from the prior day’s midpoint down 1.5 points or more! If all these offers move the bids lower, the impact could be even greater. If this seems complicated and full of uncertainty – it is – especially now that the VIX index itself is trading with an elevated volatility. The current 30-day historical (actual) volatility of the VIX is currently measured at more than 100% volatility.
The VIX is a very non-standard contract that is especially complicated and not for investors who simply want to have exposure to an increase or decrease in the volatility level. Regular options can provide that type of exposure.
Photo by Picture Perfect Pose
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