VIX spikes

Is the VIX Rigged?

05/09/2018

What if the only thing we have to fear isn’t fear itself but rather how we measure it? That’s been the concern lately about the Cboe Volatility Index®—often referred to by its pithy acronym, VIX®, but arguably better known as the fear gauge.


Why “fear”? Because the VIX attempts to measure the market’s 30-day implied volatility assumption by tracking the implied volatility of short-dated options. And why the concern about the VIX? Because from many investors’ perspective, funny things have been happening lately with the index—not ha-ha funny but strange funny.


For example, as was widely reported in the media, the VIX jumped nearly two points during the open auction period on April 18, the day VIX options and futures were set to expire. According to a follow-up letter issued by Cboe, the primary driver of the change was a buy order submitted during the auction for approximately 212,000 S&P 500® Index options across a wide range of strikes that caused an order imbalance. The result was a leap in the price of the options and thus the level of the VIX.


To hang some numbers on it, a derivatives broker estimated that the two-point change in the price of the index resulted in a $200 million change in P&L of expiring VIX options and futures. The order, submitted only five minutes prior to the 9:20 a.m. opening-auction cutoff, originated from a single market participant. This event comes on the heels of an academic publication by John Griffin and Amin Shams (both from the University of Texas at Austin) that claims to find evidence of manipulation of the VIX at settlement. 


So what’s going on here? Is someone manipulating the VIX? Does it affect the broader S&P 500 options market from which the VIX is derived? What should investors do? Let’s begin by understanding the scope of the VIX market. 


How big is the VIX?

As you can see from the chart below, since 2010 open interest in VIX futures has nearly tripled.


 VIX Futures Open Interest

VIX Chart

 

Source: Cboe. Date range represents the inception date of the VIX futures, and open interest figures represent end-of-day numbers. For informational purposes only and not to be used for investing purposes. Not an offer to buy or sell securities.


These futures, which expire monthly, have open interest with reasonable liquidity going out six months. Options on VIX futures have experienced similar growth. Is it likely that everyone trading VIX futures and related options is participating in a rigged market? The answer is no. A market that’s lasted as long as this and experienced this type of growth isn’t likely to be based on false information.


Further, those trading S&P 500 Index options—the very options used to calculate the VIX (out-of-the-money options with a maturity greater than 23 days but less than 37 days)—are also unlikely to be participating in a rigged market. There’s simply too much liquidity in that market for a price anomaly to be sustainable.


So are the media and academic articles wrong? The answer to that is also likely no.


So what’s really going on with the VIX?

The reality is that the monthly settlement of VIX futures and related options, which usually occurs on the third Wednesday of the month, is a messy process. As many recognize, it can be open to manipulation. However, it’s also possible, as Cboe has argued, that option orders submitted around this expiration are simply from investors replacing their expiring VIX futures exposure.


Either way, the activity in question is limited to a very small window around the expiration of VIX futures and related options. In other words, no one is claiming that price irregularities are systematically occurring outside of the expiration day. Further, these short-term price discrepancies aren’t likely to have any sustainable impact on VIX futures, related options expiring in the future, or on the S&P 500 Index options used to calculate the VIX. There’s simply too much liquidity in the market.


The bottom line

Just because something looks suspicious doesn’t necessarily point to evidence of guilt. Some expirations—not all—are associated with lower liquidity, which implies that a small trade can have a big impact on price. But if we’re being truthful with ourselves, we have to admit that a large option trade submitted in the final minutes of the opening auction on the day of VIX futures and option expiration doesn’t feel right.


Regardless, this flurry of concern about the VIX highlights the need to be certain when navigating derivative trades around expiration. The primary lesson for investors here is to be wary of holding a derivative contract to expiration unless you have complete transparency into—and confidence in—the expiration process. If that’s not the case, consider extending or closing out your positions prior to expiration.

Potential Parametric Solution:

We manage over $17 billion in investment strategies that seek to capture the volatility risk premium (VRP), a risk premium that can also be accessed through VIX futures. The VRP is a well-researched return premium evidenced by the discrepancy between the implied and realized volatility of equity index options, the very options used in the construction of the VIX. Parametric has developed a series of sophisticated VRP strategies in an effort to meet different investor objectives.



Tom Lee

Tom Lee, CFA - Managing Director - Investment Strategy & Research

Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport Centers. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has co-authored articles on topics ranging from liability driven investments to risk parity.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. 

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