Making Sense of a Seemingly Impossible VIX Settlement

So you want to be a CBOE Volatility Index (VIX) rock 'n' roll star? Just don't leave a position open heading into expiration. Your odds are probably better playing daily fantasy sports head-to-head vs. IBM's Watson.

Just to refresh, VIX futures and options cash settle on the morning of their expiration day. Regular November VIX options expired on the opening rotation Wednesday. The important point is that it's a calculated VIX (symbol VRO). It's based on the opening print or quote in all qualified S&P 500 Index (SPX) options series. Since not all series open at the same time, the actual VIX prints you see on the board near an expiration day open may not be identical to the VIX settlement price. But they usually bear some sort of relationship.

But not always. As in, yesterday. Here's how VIX itself looked near the open:

That big red stick is the opening minute. VIX figured to open down as the market was modestly strong. But that far down? Odd. The large range is kind of strange, too, considering the market open was relatively quiet. But hey, it's VIX expiration, so we do expect some quirks. And someone clearly wanted to jig the VIX settlement price down, right?

Well, maybe not so much. The VIX range of the first minute was 18-18.93. In fact, that was the range of the first 40 minutes, too. Yet the VIX settlement price was 19.16.

Wait, what? How is that possible?

Again, VIX "settles" on a calculation, based on the implied volatility of all qualified SPX series. A series qualifies if it has a transaction, provided at least one of the two series closer to the money have a transaction. In other words, the December 1,900 puts will make it in if either the December 1,905 puts or December 1,910 puts trade. Once two series in a row don't trade, then nothing else further from the money is in the calculation.

As "luck" would have it, every SPX December put on the board qualified for the calculation. I mean literally every series; there was a trade in December 100 puts. Some strikes saw no volume, but not two consecutive strikes, so literally every quote made it in.

I'm not entirely sure how this transpires, though I'm guessing interested parties cross a whole phalanx of worthless put spreads at zero. Whatever the case, it happens and it settles VIX at an artificial price -- and someone clearly makes out quite well on the cash-out. It always happens, though it's not usually this absurdly disconnected from actual VIX. Your only defense is to not let any position sit open into the runoff and exposed to a price move that, dollars to donuts, will not work in your favor.

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