Hello, everyone, and welcome back to the world of VIX options. Last week I got on this subject again after reading an excellent post in the Daily Options Report. One aspect of VIX options I've always meant to explore in this blog is their expiration. VIX options are tricky and unique in several ways, as I've explained here before, and their expiration is also a bit different.

Wednesday, not Friday

VIX options expiration usually falls on a Wednesday, in contrast with "standard" options that usually expire on a Friday. Why? Let's start with a little backstory, explained very well in this quote from the CBOE's site:

"VIX was designed to be a consistent, 30-day benchmark of expected market volatility, as measured by SPX option prices. Of course, there is only one day in the life of any option that is exactly 30 days to expiration, so in order to arrive at the 30-day standard, VIX is calculated as a weighted average of options expiring on two different dates."

That's a little dense, so let's break that thought down. In a nutshell, the previous paragraph means that there's only one day of the month in which the VIX option is truly a 30-day option. On this day, the implied volatility (IV) of that one 30-day SPX option makes up the entire value of the VIX. I guess the inventors of the VIX options thought this would be the perfect day to settle the VIX options, so they made that magic day the day the settlement value is determined. As it happens, that day usually falls on a Wednesday; technically speaking, it's the day that is exactly 30 days prior to the third Friday of the following calendar month. (Note that the third Friday of the calendar month is usually expiration day for "standard" options.) Sometimes the VIX Wednesday falls just before the "normal" expiration Friday, and sometimes it's just afterward.

Settlement, Euro-style

The VIX settles "European-style", so the last day to trade the contract in the marketplace is the day before the settlement value is determined, usually a Tuesday. The actual settlement value is then determined at the Wednesday open.

Here's another tricky detail about the VIX: to look up its settlement value you use the symbol VRO, not VIX. Strange, I know, but it's useful to keep in mind. To save confusion, I've gathered all the settlement dates for the VIX in 2008 in this table. Just keep in mind that the final day of trading these options is the day before.

2008 Expiration Dates for the VIX
(Last trading day is the day BEFORE these dates)
January 16, 2008
February 19, 2008
March 19, 2008
April 16, 2008
May 21, 2008
June 18, 2008
July 16, 2008
August 20, 2008
September 17, 2008
October 22, 2008
November 19, 2008
December 17, 2008

I realize all this can be confusing, so feel free to send your questions on the VIX or its options my way.

Regards,
Brian (OG)

[image: Used Watches by Sonya Sonya on flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.

Thanks for the info, Brian. This was new stuff to me.

 But I have a more fundamental issue with index options.  I have to admit that I just don't get index options. With a stock option I know I am buying or selling a contract to buy or sell a security at a specific price, but what I am buying or selling with an index option? An index is a statistic. It's an average. Why would I want to buy a numerical average? Why does an average have monetary value? To me, it seems like pure betting, since you are not trading something that has concrete value, but I'm sure there's something I'm missing.

I would really appreciate it if you could shed light on this for me.

Index options are cash settled. This means that the underlying never changes hands like it could with stock options. The index is just a gauge to tell you how much cash will change hands between the buyer and the seller of the option. A VIX example would be if you were long the 25 call option and at expiration the VIX settled at 27. The buyer of the call would receive $2 or $200 per contract from the seller for each contract that she was long. Below is a list of some blogs on index options that I wrote back in the day, you might want to peruse them.

Index options explained: part 1 posted 03/26/07
Index options explained: part 2 posted 04/09/07
Index options explained: part 3 posted 04/09/07
Index options explained: part 4 posted 04/16/07

Regards,
Brian (Og)

Thanks Brian, I will check out your old posts when I get a chance.

Unfortunately the fact that index options are cash settled still does not asuage my confusion.

It seems analagous to paying cash for the average height of grass in Texas at the end of July. You could do it, but why would you?  The height of grass may be useful as an indicator of something (drought for example), but it has no value in and of itself.

*cracks up*

Man, Will, I wish I could send you guys some of our rain from the NYC area.  The sump pump in my basement has been running nonstop for almost three days. Just like last March (no wait, last March was MUCH worse: my parents had a pond surround their house and flow into the gaps under the doors).  I am damn sick of rain.

OK Brian, I've read all of your old posts and, while they are great at explaining how to use options or etfs to hedge and speculate, they still don't answer my question. I just don't get why someone would pay for an index.

See, I totally get trading for ETF options, and I do it all the time with SPY, QQQQ, and EWZ. With those I know I am paying for a contract for a specific bunch of stocks.  But with an index option, I would be paying for the weighted average of the current price of those stocks. Which is a number. And while a number can be very informative, it has no intrinsic value. If I am buying an option for EWZ, it includes a certain number of RIO shares and those have value to me. If I am buying Bovespa, I guess I am buying the number that is affected by what Rio is currently being sold for, and that has no value to me.

 Come to think of it though, I guess it's just like gold vs. paper currency. One has real value and one has percieved value. I am personally more comfortable with trading the concrete thing than the abstract thing.

PS.

The concept of paying for the VIX is EVEN WEIRDER to me than paying for a stock index. With a VIX option you are paying for (I am guessing here) the standard deviation of a log normal distribution of some underlying index.  Thay is even more abstract than paying for an average.

Wow - Ya'll were busy when I was away. The VIX index is the most abstract of all indexes. I enjoy the question "what is the implied volatility of the options on the implied volatility index." I agree that there is no one solid underlying to track and it makes all indexes a little abstract. But as far as taking possession of the underlying verses cash settled it really does not matter. As a matter of fact on average only 17% of all option contracts are exercised each expiration. Most option contracts are closed out before they even get to expiration. So when you think if it most options are pseudo settled in cash anyway. The VIX is one of my favorite products to trade. I like it because of all the reasons at you mentioned. There is no Management team to evaluate; there are no annually reports to study. The VIX is what it is; the thing the VIX won't do is climb to 700 like GOOG and then drop to 400. This is why I like this crazy and volatile index. For example you could sell the 30 call and buy the 32.50 call and the VIX could go to 50 tomorrow and be back below 30 before expiration. It would be hard for a stock to do something like that. Remember you must consider our personal financial conditions, goals and risk tolerance before deciding which strategy to employ.

Regards,

Brian (Og) 

Hi Brian,

I have a question about expiration of vertical spreads on stocks.  The issue is that when one leg is in the money and the other leg is out of the money, I just want the in the money amount and not the underlying stock in a long or short position.

For example suppose I have a vertical call spread between 45 and 50, and I hold it over the weekend of expiration.  My understanding is that if the stock is below 45 the spread just expires worthless, and if the stock is above 50 the spread exercises for a net of $5 and I get that amount less fees.  However, my concern is that if the stock is in between, say 48, I will end up Monday owning the underlying shares.  Of course I can sell them immediately, but there are two problems: 1. I may not have enough money to buy them in my account 2.  The price may drop between expiration and my sale.

Is there anyway I can authorize you guys to just always immediately close out any net long or short shares as a result of an expiring option being automatically exercised ?  I want to buy vertical spreads, hold them through expiration and just get the net value less fees in cash.  In fact I would not mind authorizing you guys to always sell my spreads the Friday before expiration (you probably have that authority already), if you can always get the in the money amount within say about $0.05 and there are not a lot of extra fees.

Thanks,

Jon

I see you ordered the same drink from two different bartenders ;-)
Our CEO framed the answer to your question very eloquently - below is his response. I will add a couple additional comments. Most spread traders would just close the position in the open market if the stock looked like it was going to finish between the strikes. Actually, 48% of all options are bought or sold to close the position and never make it to expiration. This is the simplest alternative; if the entire spread is closed there are no worries about exercise and assignment procedures. Another option is to trade the underlying stock in the after hours market, do the opposite of what the exercise would be, this would be done after the "normal" market is closed on Friday and the settlement price is determined for the underlying stock. DISCLAIMER: if you have not done that before make sure you call the trade desk and ask the best way to proceed. Hopefully the after hours market is a decent market (the bid/ask spread is narrow), it normally would be for a large stock like IBM or MFST, but if it is on a stock that trades once month by appointment the after hours market is not going to be a viable option.

Regards,
Brian (Og)

Jon,
Your question is a responsible one and is a common source of concern among spread traders. Because you mention stock, I will assume you are referring to equity options, and not index options. The type of option we are discussing is important as it changes the answer significantly. "I just want the in the money amount and not the underlying stock in a long or short position." The type of settlement described here is called cash settlement, where money is exchanged instead of shares. This only occurs with index options. Equity options are settled in shares, so it is not possible to simply receive the monetary value in your account. I will explain more about this in a moment.
Thanks for including various scenarios. Just to make sure we are on the same page, I would like to comment briefly on the in the money example. "If the stock is above 50 the spread exercises for a net of $5 and I get that amount less fees." This statement is true; however you will also need to factor in your initial cost in order to calculate your net profit (or net loss).
"If the stock is in between, say 48, I will end up Monday owning the underlying shares." You are correct. If the stock is in between the strikes, you will end up buying the stock. The reasons you mention are also valid issues, with #2 being the graver concern, "the price may drop between expiration and my sale." The only way to prevent further market risk is for you to place an order to close out both sides of the spread. This may be done up until the last day of trading for that month. (Note - the last day varies for many index options.) It is not possible for us to automatically exit your positions with an advance request such as you described. To assist in submitting these orders, you may choose to utilize our Good Until Cancelled function (GTC orders). The only thing that is processed automatically is the exercise or assignment. As you may already be aware, any position that may result from an automatic exercise or assignment is ultimately the customers' responsibility. Thank you for being proactive in managing your account and bringing your questions to our attention.

Best regards, Don

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.

We currently don't have the ability to allow "not held" trades on expiration. The concept of self directed trading is that all the decisions are made by you, even the ones at expiration. This for legal reasons and the way we (TradeKing) are set up as a brokerage firm.

Regards,
Brian (Og)