VIX Options and Futures

VIX Options FAQ

1. What is VIX?

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.

2. How is VIX calculated?

calculation is independent of any theoretical pricing model, using a formula that averages the weighted prices of at-the-money and out-of-the money puts and calls to derive expected volatility. More information and a sample calculation may be found at the VIX White Paper.

3. How do VIX options allow me to trade volatility?

The VIX formula isolates expected volatility from other factors affecting option prices, such as changes in underlying price, dividends, interest rates and time to expiration. As such, VIX options offer a way for investors to buy and sell option volatility simply and directly, without having to deal with the other risk factors that would otherwise have an impact on the value of an SPX option position.

4. I'm used to options expiring on the third Friday of each month. Why do VIX options expire on a Wednesday?

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.

One day each month, on the Wednesday that is thirty days prior to the third Friday of the following calendar month, the SPX options expiring in exactly 30 days account for all of the weight in the VIX calculation. VIX options settle on these Wednesdays in order to facilitate the special opening procedures that establish opening prices for those SPX options used to calculate the exercise settlement value for VIX options.

5. Will VIX options always reflect current, real-time, VIX values?

Probably not, at least not until you get close to expiration. 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. In fact, June SPX options do not even enter into the spot VIX calculation until April 17, 2006.

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. For instance, if spot VIX experienced a big up move, call option prices might not increase as much as one would expect. Depending on the value of forward VIX, call prices might not rise at all, or could even fall! As time passes, the options used to calculate spot VIX gradually converge with the options used to estimate forward VIX. Finally, at VIX options expiration, the SPX options used to calculate VIX are the same as the SPX options used to calculate the exercise settlement value for VIX options.

6. How is the exercise settlement value for VIX options calculated?

The exercise settlement value for VIX options (Ticker: VRO) is a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices of the SPX options used to calculate VIX at settlement. Most of the SPX option opening prices typically reflect actual trades. The opening price for any series in which there is no trade is deemed to be the mid-quote price, the average of that option's bid and ask prices. Only series with non-zero bid prices upon completion of the special SPX opening procedures are used in the SOQ calculation.

7. How is the calculation of the VIX SOQ different than the calculation of other VIX values? What can this mean for VIX options settlement?

It is important to note that the VIX SOQ is the only VIX calculation that uses traded prices. Every other reported VIX value uses mid-quote prices of SPX option series. Typically, the theoretical VIX bid/ask spread (i.e., the difference between VIX calculated using bid prices and VIX calculated using ask prices) is 0.8 to 1.2 VIX points. If the VIX SOQ is calculated using predominantly bid prices, or predominantly ask prices, there may be a significant difference between the exercise settlement value for VIX options and the reported VIX values (based on mid-quote prices) on expiration day as well as at the close on the day before expiration.

8. Why do VIX option prices appear different than other index option prices I'm used to seeing?

The price of any index option depends on the forward price of the index and the expected shape of the forward price distribution. In the case of stock indexes like the S&P 500, the theoretical forward price is determined in a fairly straightforward manner that considers the "cost-of-carry" (i.e., interest rates and dividend yields). Forward prices of option volatility exhibit a "term structure", meaning that the prices of options expiring on different dates may imply different, albeit related, volatility estimates. VIX option prices reflect the market's expectation of the VIX level at expiration, as measured by the VIX SOQ on that date. For example, prices for VIX options expiring in May 2006 reflect the expected volatility implied in June 2006 SPX options; VIX options expiring in August 2006 reflect the expected volatility implied in September 2006 SPX options, etc. The VIX volatility implied by June SPX options may be significantly greater or lower than VIX volatility implied by September SPX options.

Most readily available option pricing models assume that price changes in an underlying asset - IBM or S&P 500 Index (SPX), for example - have a lognormal distribution. The distribution of VIX prices is not lognormal. In a lognormal world, the price of IBM, for instance, could go to $0 per share, or rise to very high levels depending on market conditions and company fundamentals. A VIX value of zero, on the other hand, would imply a market expectation of virtually no daily change in the level of the S&P 500 Index! Extreme or persistently high VIX levels are just as unlikely because there would need to be a market expectation of very large daily SPX index changes over an extended period of time.

Option practitioners commonly refer to the unique behavior of VIX and other volatility measures as "mean-reverting," which is a statistical way of saying that at historically low VIX levels, there is a higher probability that the next big move will be up rather than down. Conversely, at historically high VIX levels, the next big move is more likely to be down rather than up.

Because of these differences between VIX and traditional stock indexes, calculating exact theoretical values for VIX options can be very complex. Assuming that VIX option prices reflect the "term structure" and "mean reversion" characteristics of VIX, VIX options could appear somewhat peculiar relative to other index and individual stock options.

9. What is the "volatility of volatility"?

The expected volatility of VIX forward prices is another important factor influencing VIX option prices. But what is the "volatility of volatility"? It turns out that volatility, as measured by spot VIX values, is indeed very volatile. As shown in the following table, the volatility of the VIX Index was higher than the volatility of the S&P 500 Index (SPX), the Nasdaq-100 Index (NDX) and the Russell 2000 Index (RUT), and several stocks, including Google, Apple and IBM.

NAME 12/31/08 Price 2008 Volatility VIX 40.00 127.3% VIX Near- term Futures 41.94 88.9% SPX 903.25 41.0% RUT 499.45 46.4% NDX 1,211.65 42.3% GOOG 307.65 55.2% AAPL 85.35 58.2% GM 3.20 115.7% IBM 84.16 36.1% MSFT 19.44 48.5% C 6.71 116.8%

NAME 12/31/09 Price 2009 Volatility VIX 21.68 88.9% VX Near- Term Futures 22.95 69.2% SPX 1,115.10 27.3% RUT 625.39 36.2% NDX 1,860.31 26.5% GOOG 619.98 30.1% AAPL 210.73 33.7% GLD 107.31 20.8% IBM 130.90 27.5% MSFT 30.48 37.3% MS 29.60 79.0%

NAME 12/31/10 Price 2010 Volatility VIX 17.75 115.7% VIX Near- term Futures 19.70 74.9% SPX 1257.64 18.0% RUT 783.65 25.0% NDX 2217.86 19.5% GLD 138.72 16.5% GOOG 593.97 27.9% AAPL 322.56 26.7% GS 168.16 31.2% AMZN 180.00 32.7%

Yet, there is another "volatility of volatility" to consider. The underlying for VIX options, as noted earlier, is the group SPX of options that will be used to calculate the exercise settlement value at expiration; that is, forward VIX. Historically, forward VIX has tended to be less volatile, on average, than the VIX index itself. In recent years, for example, the volatility of forward VIX (as measured by near-term VIX futures prices traded at the CBOE Futures Exchange) was significantly less than the volatility of the spot VIX.