Following up on Enis’s recent posts on spot VIX and VIX futures, I wanted to start an occasional series where we discuss these types of things with other experts in the industry. My former colleague Dominic Salvino from Group One Trading is not only the VIX options specialist on the CBOE but was on the committee that helped develop VIX products. I asked him if he could give a basic description of how the VIX options work. Here’s his reply via email:
The starting point is understanding the futures. Trying to understand the options first is too complicated. So let’s start with futures. The Sept future is due to mature (options expire, futures mature) Wednesday morning. Their final settlement is set by the opening print of the OCTOBER SPX options. October not September in the spx because the VIX is a 30 day forward. A strip of Oct SPX options (all otm) will decide the settlement value of the Sept VIX futures. The formula to get the settlement price from the various option prices is fairly complicated for non-pros but if your readers are interested they can get the exact formula from the CBOE website. Basically, the formula heavily weights the otm (out of the money) puts relative to the otm calls, so they want to pay particular attention to those lines. Working by analogy, the Oct VIX future will settle in October to the opening prices of a strip of November SPX options. And so forth.
The futures trading is extremely heavily weighted to the front two months. This is almost entirely due to the ETPs in volatility. The granddaddy of vol ETPs is the VXX etn launched by Barclays. It still holds the lion share of the dollars in volatility. The VXX is structured to provide the same return as a 30 day average of the vix futures. I.e. right now it is mostly Oct vix futures with a small residual of Sep vix futures. Come expiration Wednesday, it will be identical to a pure Oct vix future position. Going forward from there, it will slowly reduce its Oct vix holding and add nov vix futures. Last I checked the stock was trading roughly 40 million shares a day. Assets under management in VXX is over 1 billion which is impressive given that it has lost 98% of its value since its launch 2 years ago.
The VXX tends to decay over time due to the contango in the vix futures. Contango means that the back month futures trade at a premium to the front month. This is the norm in most commodity markets (corn, oil, etc) and volatility behaves very much like a commodity, not an equity. The contango means that if all else holds constant, the 2nd month will slowly decay down to the front month. That causes the vxx to bleed value. If, however, something bad happened, volatility would likely explode from current levels and the vxx could easily double or triple in a very short time. That means it has insurance value against market crashes/corrections. The decay in its value during quiet times can be viewed as the premium paid for that insurance. As an aside, you see the same type of bleeding in the USO due to the contango in oil future markets. So it has nothing to do with volatility per se, more just the nature of commodities. Particularly commodities that are felt to be below long term averages in value, and the vix is currently historically low.
That is enough for one e-mail. Let me know if this all make sense and we will go from there.
For more about contango in VIX products please see CC’s cautionary tale about VIX products in his post “VIX tracking ETN’s”
You can pull up VIX futures prices on the CBOE site here.
We’ll continue this conversation with Dominic when he has time and we’ll look to do more of these interviews in the future with other experts. In the meantime here is Dominic’s CBOE tv video from Sept 10th: