Doc Maher answers Will Profit's questions.
I read your trade note on your VIX July 25 Call. You stated that on 5/27 the VIX opened +1.4 but the bid of the call was $0.10 lower. How does this happen?
Well there are several factors that may have contributed to that. First let me say that the VIX and the VIX options are more complicated than a stock option and its underlying stock. I'll get into this part of the explanation later but first I want to discuss some things that are more general in nature.
I can't say definitively what happened because I wasn't watching it and even if I was I can't be sure what was going on. However there are a couple of things I can point out that would be true for all options. This morning I looked at the option in question:
Click here for a larger image of Greeks - Image 1.
This came from the P&L tool on 5/28. The Theta is only -3.58 which means that the option would be losing value due to time decay at a rate of only -$.0358 a day. The Delta is 41.20 which means that the call option should go up $0.412 for every point the underlying (VIX) moves up. So your assumption that the 1.4 point move should have countered the time decay seems to make sense.
Unfortunately there may have been a couple of other things going on here. Notice that the Implied Volatility (IV) is 126. This is a rather high IV and it could easily move around a few points. Since the Vega, which is the amount that the option should move for a one-point change in IV, is 2.75 or $0.0275 we might not think too much about it. When I look at the IVs of the options near it:
Click here for a larger image of Strike Volatilities - Image 2.
I see that the IV changes significantly from strike to strike. The Jul 22.5 call IV is 141 and the Jul 27.5 call IV is 119. What this tells me is that the IVs are strongly skewed and may move a lot. Just in the time it took to take the two screen shots, the IV of the July 25 moved up a point. There is also something unusual about the IV on the VIX, look at the IV chart below:
Click here for a larger Volatility Chart - Image 3.
The IV Index Mean is all over the place. It has been as high as 173 on May 16 and as low as 39 on May 27. However the options we are looking at have IVs well over 100.
So it is conceivable that the IV at the open of 5/27 was lower than it was on 5/23 by enough to make the bid drop $0.10. What does this really mean? It means that the market maker changed the price. That's what changing IV is, it's just a reflection of the change in relative price. Why can they do that? The VIX is only traded on one exchange, the CBOE. This means that the Market Makers have more control. They can widen the bid ask spreads, they can change the price (IV), without having to worry about all the business going to another exchange. When an option is traded on a number of exchanges there is more competition between more Market Makers and this gives them less control.
If you watch the bid and ask for options during the day you will notice that they tend to vary more than you might expect relative to changes in the price of the underlying. If the option is heavily traded on a number of exchanges the prices tend to follow the underlying more closely but even then you will see lagging and overshooting in the options as the Market Makers respond to changing conditions and market pressure. It just tends to be less in the case of heavily-traded, multiply-listed options. Usually things will even out over time, but the time may be longer in the case of the lightly-traded single-exchange option. I know some traders that won't trade options that only trade on one or two exchanges.
So why did the bid price drop $0.10 when it seems like it shouldn't have? Well I hate to say this but the answer is basically: because it can. One last thing, look at the IV now.
Click here for a larger image - Image 4.
It's moved down to 123 just while I was writing this. The price was $2.10 in the table before and the VIX was 19.72 and now the price is $2.00 and the VIX is 19.78. What can I say?
Now having said all that, VIX options have a few quirks that you need to get familiar with to really understand what's going on. The same sort of things that happen to all options also happen to the VIX options - the bouncing IV and the issues with a single exchange etc, however there are additional complications with the VIX and its options. So while what I wrote above is applicable to most options, there is more going on with the VIX.
I'm going to simplify this somewhat so this is not exactly correct however it should help give you an idea of what's going on.
The CBOE defines the VIX this way: "...is intended to be an up to the minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index (SPX) option bid/ask quotes. ..." and "... to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index." From the CBOE: CBOE VOLATILITY INDEX® (VIX®) OPTIONS.
OK but what options do they use to calculate this? Well to calculate the values of the VIX at this moment (often called the spot value) they use SPX options from the current month and the next month in a weighted formula that changes with time.
That's reasonably confusing. But what you want to take out of that is that the VIX spot value today comes from SPX options from the June and July SPX options.
If you were to buy a September VIX option the VIX as calculated today would not even be using the SPX September options and so looking at spot value of the VIX would not be a good measure of the "true underlying" of the option. What I'm trying to say is that the September VIX option's price will be based on a calculation of the September and October SPX options, or more like what the market thinks those SPX options will do, and not the June and July ones that the VIX is using now.
So what does all this mean? Well it means that looking at the VIX at any moment, the spot value may not be a good indicator of what the VIX option prices are based on. In fact looking at the VIX future for the time period you are interested in may be a better indicator because that price is based on the market's expectation of the "future price" of the VIX. So we might want to look at the September VIX futures as a better measure of what the September VIX options are doing.
This affect diminishes as we get closer to the expiration date because the VIX options will settle on a value based on the VIX and not the VIX future. Of course the future settles on the VIX as well so they should all get lined up at expiration.
Now in the case of your July VIX option, the spot values of the VIX may not be that bad of an indicator. At least the VIX is using the June and July options to get the current value. However the market makers may still be looking at the VIX July future to help them price it.
As it turns out, the VIX July future looks to have opened slightly down on 5/27 even though the VIX (spot) opened higher as you noted. This may have contributed to your lower option bid price. I looked at charts of the VIX spot and the VIX July future, and while differing in value they seem to be more or less in sync during the last week with one exception. The gap up in the spot value on 5/27's open was not seen in the July VIX future.
Below are charts of the VIX and the July VIX future:
Click here for a larger Spot chart - Image 5.
Click here for a larger Spot / Future chart - Image 6.
You can see the gap up of the VIX on 5/27 and you can see that the VIX July future not only didn't gap up it started down. I also see that during the day the July VIX future was dropping while the spot value was more or less holding up. This variation may have contributed to seemingly "odd" behavior of the option.
Here are some specifics. On 5/23 the VIX spot closed at 19.55 and the July 25 Call bid was $2.10. By the close of 5/28 the VIX spot was 19.07 and the bid on the July 25 was $1.70. The loss of $0.40 on a drop of .48 in the VIX might seem extreme since the delta is only about 0.4. However on 5/23 the July future bid closed at 24 and by 5/28's close it was 23.20, about a 0.8 drop, which would better explain the $0.40 drop in the July option. (Table below)
Spot Future Call bid
5/23 close 19.55 24 2.10
5/28 close 19.07 23.20 1.70
Net change -0.48 -0.80 -0.40
OK, OK, bottom line here is that it's important to understand what you are trading and how it works. The VIX options are more complicated than one might think and if you are going to trade them it's best to get a good understanding of how they behave. It also helps to understand how the options market in general behaves with respect to volume and competition between exchanges.
The Options Guy has several posts that deal with the VIX. Feel free to read what he has to say:
I hope at least some of this was helpful. Don't be afraid to throw a question out if you want.
"Income Trader"
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This comment and any market data included here were completed on 5/30/08.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
The Greeks (Delta, Theta, and Vega) represent the consensus of the marketplace as to the how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct.
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 and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
