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Your Broker Probably Gets VIX Options Completely Wrong

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It's been seven years since the CBOE Volatility Index (VIX) options were launched, and some brokers and option pricing software providers haven't quite gotten around yet to reading the contract specs.

Either that, or they are, year after year, knowingly distributing false quotes for the implied volatility and greeks of VIX options. For example, with January VIX futures trading recently at $16.50 and January VIX 16 calls bid at $1.90, a very popular options trading platform owned by one of the largest retail brokerages in the country quoted the implied volatility of those near the money calls at 130%. The correct implied volatility was somewhere in the neighborhood of 59%. That's a huge difference: it's the difference between saying that the market has a reasonable-enough view about likely changes in VIX forward levels for the near term (59%) and saying that markets are wildly and systematically wrong (130%) in a way that they aren't for any other asset.

The problem isn't limited to one or two brokers, and this isn't an issue of competing pricing models; the false quotes are caused by vendors assuming, falsely, that the asset underlying VIX option quotes is the "spot" VIX index.

Neither is this a problem in some backwater, illiquid product that nobody cares about. On Tuesday, VIX options were the eighth most active issue by contract volume.

Now, in fairness, that contract specifications page I mentioned could be a little clearer. Here's the description for the asset that underlies VIX options:

"Underlying: The CBOE Volatility Index - more commonly referred to as "VIX" - is 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. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index."

That's just a description of the spot, 30-day index. So you can see how some people might be confused. To find the real answer, you should look elsewhere, to the answer to question #5 on the FAQ page. These sentences are more important than anything I have to say, read them:

"The underlying for VIX options is the expected, or forward, value of VIX at expiration, rather than the current, or "spot" VIX value. This forward value is estimated using the price quotations of SPX options that will be used to calculate the exercise settlement value for VIX on the expiration date, and not the options used to calculate spot VIX. For example, VIX options expiring in May 2006 will be based on SPX options expiring 30 days later - i.e.; June 2006 SPX series.....Some VIX options investors look at the prices of the VIX futures to gain a better general idea of how the market is estimating the forward value of VIX. VIX option prices should reflect the forward value of VIX, which is typically not as volatile as spot VIX."

Take two things from that quote. First, for the purposes of trading VIX options, you might as well ignore the spot VIX index. Under almost no circumstances should you take the spot VIX as the underlying used to price VIX options.* But that's exactly what many brokers still do, and that's why they output silly greeks and false implied volatilities. The closest analogy I can think of would be if you priced corn options expiring in June using the spot price of corn in November, ignoring the storage costs and other factors that might cause a large difference between the price of corn at those very different dates. Maybe a more clarifying analogy would be if you priced an option on Apple (AAPL), with the stock trading at $520, as though the shares cost only $400. If you make such a basic error, of course everything that depends on that input will be wrong.

The second thing to take from that quote from the exchange is that the underlyings for VIX options are also not VIX futures. Even professionals get this wrong sometimes. The underlying for VIX options is the forward value for the VIX index at the expiration date of the options, which is based on the prices of SPX options for the contract months that will be the first and second contract months when those VIX options expire. The reason people pay attention to the futures is that the forward value of VIX tends to be similar to the prices of VIX futures.

If you're wondering whether your software provider or your broker has things properly set up or not, you should probably call and ask them. Eventually, if you complain more, things'll get fixed. In a follow-up piece, I'll look at two ways you can check VIX IV quotes yourself.

* The exception would be as you approach VIX options expiration. But you probably shouldn't be trading VIX options around expiration, either, for other reasons.

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At the time of publication, Jared Woodard held positions in VIX.

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