The Price Relationship of VIX® Options to the VIX® Index and VIX®Futures
At times, VIX option contracts may appear to be mispriced relative to the VIX index. This phenomenon is the result of the anticipatory nature of forward implied volatility relative to the current level of the VIX index. Although VIX options settle to the VIX index at expiration, prior to expiration prices of VIX options are based on expectations of what the VIX index will be at expiration. This expectation of what the VIX index will be at expiration also appears in the pricing of VIX futures contracts. As a result of this market dynamic, traders are advised to consider the price of the corresponding VIX futures contract when making trading decisions regarding VIX options.
Consider the following example:
This shows the VIX index at 25.00 and the VIX August call with a 20-strike at 3.00. Given the VIX index at 25.00, many traders would expect a VIX 20-strike call to be trading for at least 5.00. If, however, the August VIX futures contract, which is trading at 21.50, is considered as "the underlying;" then the price of the 20-strike VIX August call seems reasonable.
This example illustrates why the "relevant VIX futures contract - the contract with the same expiration date as a VIX option - is considered "the best underlying instrument" for VIX options.
Similar pricing relationships also appear at times in VIX put options. Consider the following example:
This shows the VIX index at 20.00 and the VIX put with a 25-strike at 4.00. At first glance, it might appear that the price of 4.00 for the VIX September 25-strike put is 1.00 below parity. However, given the September VIX futures price of 22.50, a price of 4.00 for a 25-strike VIX September put seems reasonable.