How To Manipulate VIX Settlement Price

VIX expiration day often coincides with particularly heavy trading activity in underlying SPX options. VIX settlement value, or VRO rarely matches either the Tuesday close or Wednesday open prices on the "cash" index, prompting pundits to blame VIX settlment for being manipulated. A popular theory is that VIX settlement value is being pushed up or down with huge SPX trades, referred to as "carpet-bombing". Some say that the manipulative trades are concentrated around high-vega strikes, others concerned specifically about puts. In this post I explain why large trades are not likely an explanation for VIX manipulation, and instead how VIX settlement value can be artificially increased for less than one hundred dollars, how VSTOXX futures and options are not subject to such manipulation, and propose a simple modification that makes VIX manipulation too expensive to be profitable.

VIX settlement value is determined by a Special Opening Quotation, based on the opening trades of SPX options instead of quotes. It is true that VIX settlement value can be made higher or lower by placing a big order that would result in a trade. The quantity necessary to move ATM SPX options is significant, and such trade would have to either be maintained and hedged until expiration, or exited immediately possibly with a large slippage. For this reason I don't think that it would make sense for a trader to attempt to manipulate VIX this way - it is very costly, and possibly very risky if the market moves against the trader, and I believe that heavy trading on the open of VIX expiration does not signify VIX manipulation, but rather legitimate SPX trading activity.

However a different form of VIX manipulation is possible. The VIX calculation formula is a weighted sum of option prices, with weight proportional to 1/K^2, where K is the strike. When K is getting smaller, 1/K^2 is getting bigger. While in theory such growth in a weighting term is mitigated with declining put prices (as K is getting smaller puts get cheaper) in practice it seems possible to "blow up" the VIX by placing orders - nickel bids that are most certainly would get executed - at very low strikes. It is a rather small investment - a few cheap options with limited risk since all options are bought - no short positions.

How this would work in practice:
1. On Tuesday before VIX expiration before the close, a trader purchases a significant amount of VIX calls, ATM or slightly OTM, that have the most potential gain from an unanticipated VIX increase.
2. On Wednesday before the open, a trader places 0.05 1-lot bids on low strikes SPX puts for the next month's expiration (the expiration that determines VIX settlement)

To illustrate the idea I downloaded SPX data from the September 2011 VIX expiration available from the CBOE website here. VIX settled at 33.72, with 550 being the lowest strike traded. As I mentioned above, by construction VIX is very sensitive to the low-strike puts, and if a 500 strike had traded at 0.05 VIX would have settled at about 33.73. If 400 and 500 strikes had traded at 0.05 VIX would have settled at about 33.86; adding a 300 strike trade would push VIX to 34.06; adding a 200 strike trade would push VIX to 34.50; adding a 100 strike trade would push VIX to 36.23. To summarize, for a total cost of 5*$5 = $25 a trader can artificially inflate VIX value by 2.51 points.

500	+0.01
400	+0.14
300	+0.34
200	+0.78
100	+2.51

This methodology applies to any VIX expiration. Using settlement data from August 2011 expiration I estimate potential effects of price manipulations as above.

500	+0.15
400	+0.26
300	+0.47
200	+0.92
100	+2.69

Since the CBOE provides what they call "likely VIX series" we can know which SPX strikes were available at the time of expiration, and calculate exactly the effect on VIX index for every expiration for which data is available. The greatest effect on VIX comes from the lowest strike, so for practical implementation the strategy would depend on which SPX strikes are listed.

Economic significance of such manipulation depends on VIX options on the last trading day, and opening price of SPX. Historically the overnight VIX move from Tuesday close to Wednesday morning settlement has been rather volatile (Russell Rhoads did a study of this in his book), but I believe in most cases the trade would have a very large upside with limited downside.

VSTOXX - a pan-European volatility index based on EURO STOXX 50 index is not subject to such manipulation. The contract is settled into an average of index values during a half hour period on the last trading day (here)

The Final Settlement Price is established by Eurex on the Final Settlement Day, based on the average of the index values of the underlying on the Last Trading Day between 11:30 and 12:00 CET.

This certainly makes sense given that VSTOXX expires in the PM. However now that SPXPM options are picking up some volume on C2 I think it would make perfect sense to calculate VIX values based on a similar averaging procedure as VSTOXX that makes manipulation very expensive and practically impossible, or the CBOE to offer a different settlement procedure that is more resistant to manipulation.