Schaeffer's Outside the Box Blog
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Nothing gets a good VIX-over-interpretation-fest going like the one day per cycle when CBOE Market Volatility Index (VIX) options roll out. We had just that sort of day Monday, and I could hear it all the way on vacation.

I mean … seriously. I clicked on The Twitter a couple of times and I could feel the consternation in the air. In all fairness, however traders in my feed seemed to follow it and were noting the Wizards of Financial Television were in full confusion mode.

This is a shame, because it's a relatively simple concept. The VIX incorporates the two nearest S&P 500 Index (SPX) expiration cycles into its calculation. Remember, this calculation is designed to proxy the implied volatility of a hypothetical 30-day SPX option. The two near-month cycles generally bracket those 30 days, and are weighted accordingly.

For the long, math-y explanation of why the roll can cause a blip, here's the VIX white paper (with a tip of the hat to Bill Luby):

The components of VIX are near- and next-term put and call options, usually in the first and second SPX contract months. 'Near-term options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration. When the near-term options have less than a week to expiration, VIX 'rolls' to the second and third SPX contract months. For example, on the second Friday in June, VIX would be calculated using SPX options expiring in June and July. On the following Monday, July would replace June as the 'near-term' and August would replace July as the 'next-term.

At the time of the VIX 'roll,' both the near-term and next-term options have more than 30 days to expiration. The same formula is used to calculate the 30-day weighted average, but the result is an extrapolation of σ21 and σ22; i.e., the sum of the weights is still 1, but the near-term weight is greater than 1 and the next-term weight is negative (e.g., 1.25 and – 0.25).

Or for the un-mathy nickel version that works great at cocktail parties…

When the near month gets to within eight days of expiration, VIX rolls the whole cycle out of the equation. This can cause 1-day blips in the VIX if the cycle that rolled out carries a significantly different implied volatility than either the cycle that's brought in (or the now re-weighted second cycle out).

Why would this cause the VIX to actually blip lower when the new cycle (in this case, January) carries a higher volatility than the one being removed (November)? Well, as per the confusing formula above, the January series actually has a negative weight in the new number.

And, no … I'm not sure I can wrap my arms around that either, but if it's in the formula, it's part of the number and can at least help explain it.

Most importantly, it can cause a change in the VIX, even if the implied volatility has not budged in any of the front three expiration cycles. It's the definition of statistical noise.

Consider an extreme example.

Let's say market-shaking news is expected on the Tuesday of expiration week. The near-month options trade at an enormous implied volatility, but the rest of the options board carries only slight news premium. On Friday, a week before expiration, the VIX includes the near-month options. But now Monday comes, and the options no longer figure in. VIX stands to get clubbed a bit, just by the simple act of changing the components of the calculation. But implied volatility hasn't actually moved. The near month is still bid up ahead of news -- it's just not part of the VIX anymore.

It's a good lesson in general not to overreact to odd VIX moves, but especially so on "roll" day. The move literally means nothing.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.


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