This is the third part of an occasional series where we discuss specifics 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. In the previous posts (here and here) he spoke about VIX futures and VXX. Here he brings us to the options:
Which brings us to VIX options. The CBOE has always been a leader in the options industry and it was planned from the beginning to have options as well as futures on the VIX. Cash settled options, however, are governed by the SEC rather than the CFTC so the regulatory process for them took much longer. Options launched in the end of February 2006 or about 2 years after the futures launch. They were successful pretty much from the beginning and have an unparalleled secular growth over the last 6 years. Needless to say, the liquidity has deepened enormously since those first days and the bid ask spread has shrunk accordingly.
The first thing a trader needs to understand when looking at VIX options is that they are a COMMODITY like option rather than an equity type. The pricing is far more similar to say corn or oil options than to the SPX or IBM. Equity and equity index options price off of a single underlying. Even SPX options, which does have different maturities of futures available, actually only prices off of the liquid front month future. The back months of the SPX options are priced off of that liquid future plus a fairly stable interest rate/dividend correction. Commodity options have multiple underlyings to the extent that there isn’t a solid connection between the different maturities of futures. The VIX futures are even more unlinked to each other than in most agricultural, metallurgical, and energy futures because there is no cash and carry trade. So each VIX options month has to use its own future as the underlying driving its pricing. This leads to markets that may seem nonsensical to someone who has only traded equity options. For example, when the futures market is in deep contango, the back month futures will be much higher than the front month future. But that means that very deep put calendars will trade at a credit as the front month put will be more valuable than the back month put. Conversely, if the market is in steep backwardation, the call calendar could trade at a credit. These are not arbitrage opportunities as they would be in equity options, they are simply reflecting the discount or premium found in the futures market.
The second unusual feature of VIX options is their skew profile. Since the VIX is strongly negatively correlated with the SPX, its skew curve is inverted compared to the SPX. I.e. the out of the money (OTM) calls are far more expensive than the OTM puts. This is the opposite of what is seen in the SPX and reflects their negative correlation. The skew is often extremely steep as the VIX has shown itself to be far more sensitive to market moves than the SPX itself. Even the at the money (ATM) vix options trade considerably higher than the SPX atm options (current front month vix atm options are at 85 whereas the spx atm options are at 15). The OTM vix calls are even more extreme, often going as high as 200! This reflects the value of crash protection that the VIX is felt to provide. If the spx were to fall 10% in a single day, the VIX is expected to rise by far more than 10%. At current levels, a 100% upside move would not be impossible in such a crash scenario.
The third feature I would highlight here is the lower implied volatility of back month options relative to front month options. The farther out in expirations you go, the lower the implied volatilities of the VIX options in that month. The reason for this is the mean reversion in the VIX itself. Volatility behaves much more like interest rates than equities. It may get crushed, it may skyrocket, but eventually it will come back to some long term average. If IBM were to double next month, there is no expectation that it is will likely lose those gains over the next several months. Volatility is obviously different in that if it spikes, it would be expected to eventually relax back down. That is why the futures market would be in backwardation. Conversely, if it is trading below historic norms, the market expects it to eventually rise back to those averages. That is why the futures market in a low volatility environment shows contango. This mean reversion reduces the value of back month contracts relative to front month contracts as it reduces the movement of those futures until they are themselves of short enough duration to ignore it.