The VIX Glitch and the Elephant In the Room

The CBOE Volatility Index's (VIX) Aug. 24 snafu was blamed on a change to how the 'fear gauge' is calculated

Oct 8, 2015 at 8:48 AM
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Remember those long minutes back on Aug. 24, when there was no CBOE Volatility Index (VIX) to quote? We may finally have an explanation of what went wrong. This, from Saumya Vaishampayan at The Wall Street Journal: 

"The analysts believe the issues with calculating the VIX that morning stemmed from the recent change in how the index is calculated. The CBOE last October started including weekly S&P 500 options in its calculation of the VIX, marking the first change to the index since 2003. Previously, the index was calculated using monthly S&P 500 options.

The difficulty in calculating the VIX stemmed from those weekly S&P options, or 'non-standard expirations,' the analysts say. Quotes for the weekly S&P 500 options used in the VIX calculation were 'much more intermittent' that morning than the quotes for other S&P 500 options, they add." 

That actually makes some sense. Don't forget, VIX isn't some magical entity unto itself. It's just a calculation based on the implied volatility of certain S&P 500 Index (SPX) options. And when some of those options have wide or non-existent quotes, you will get either a VIX that jumps all over the place or, as in this case, no VIX at all. 

There's an important point about this, though: It really doesn't matter in the larger scheme of things. Way back before VIX was born, traders actually knew the implied volatility of any option they traded. I can confirm that from personal experience. Even years after VIX existed, no one paid enormous attention to it. That's because at the time, VIX simply proxied implied volatility of index options (OEX options then) and put it on everyone's screen in easily quotable form. 

But alas, you say, times are different. There are myriad popular derivatives based on VIX. It matters much more now. To which I say, that's true, but even those VIX derivatives don't need an actual VIX at all times. From the aforementioned WSJ story:

"The analysts also note that while the VIX couldn't be calculated, VIX futures were 'alive and kicking' in that first half hour of trade. Additionally, the VVIX, which gauges expectations for volatility of the VIX, was able to be calculated. 'In other words, while investors did not know the level of spot volatility, they did know its expected level in one month and the level of spot volatility-of-volatility!,' the Barclays analysts led by Maneesh Deshpande said." 

How did they do that? Well for one, you could still see implied volatility at the time, you just had to look a little deeper. For another, the derivatives all price off a future-settled VIX value, and don't hinge on every last VIX tick. Especially so on a day VIX was clearly exploding… even if you didn't know precisely how high. There was going to be huge mean reversion priced in whether VIX opened at 40, 50, or 60, and the actual tick wasn't going to impact those mean-reversion assumptions all that much. 

Of course, the elephant in the room is if something like this happens on an open where VIX settles. Now that there are weekly VIX futures and options, there's a VIX settlement every week. We wrote this up at the time, but it's worth re-noting that if there's a large time lag between opening quotes in SPX options, it's going to beget a very arbitrary and unfair (to one side) settlement price in expiring VIX futures and options.

And THAT would, in fact, cause some serious issues.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.



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