CBOE announced yesterday that they will start listing SPX weekly options series with the same expiration time as VIX options. While it is not clear from the press-release, the circular clearly states that new options will be PM-settled, adding half-day of basis risk for traders. Overall I think this contract specification is somewhat surprising, but let's go over the history of VIX to understand CBOE's position.Original VIX, as introduced by CBOE in 1993 was based on OEX (S&P100) options, most liquid index options at the time, and calculated by interpolating Back-Scholes implied volatililities of ATM options; OTM options did not figure in the calculation. VIX was already in use for 10 years, when in 2003 CBOE updated VIX methodology in two ways - first, moving from OEX to SPX, more liquid index options market, and changing the calculation to be in line with a formula for a variance swap - an OTC instrument that allowed for a pure (as in no delta, no rebalancing required) bet on variance.
While not exactly the same (VIX is a square root of var-swap, a non-linear transformation which makes static replication impossible) VIX futures and options became a class of its own. The original foundation of VIX vs basket of 30 day SPX options became less important as VIX complex became the dominant market leading the price discovery in volatility.
However that led to some inconvenience for traders - if you have two correlated markets like SPX and VIX, and you treat them as observable (as opposed to some model based latent quantity) you would want to naturally trade one against the other. However with Wednesday vs Friday expiration this adds significantly to residual risk. But current solution (Wednesday PM) begs a question - why PM? Trading VIX vs SPX Wedensday options still leaves half-day of difference?
I called CBOE (so you don't have to) asking for a comment. After being transferred from one person to another I received an answer that can be summarized as "we cannot comment on product design decisions" . Basically what it means is that CBOE decided to add another day for expirations, and designed the product to be similar to existing weeklys (PM). They were not meant to perfectly align with VIX complex, despite what it says in the press-release.
FWIW I think this is actually an unfortunate decision, and lost opportunity for CBOE.
agreed, nobody will trade these. should have just made them AM, and just once a month, to start with.
ReplyDeleteActually, I'll probably start putting some trades if spreads are tight ...
ReplyDeleteI suspect the reason that the CBOE did not go for the AM settlement was because of the risk of delayed opens. As we saw in 17-Aug-15 this can get pretty ugly and adds uncertainty exactly when things are most important in the volatility world. At least with PM settle people know they can't rely on a near simultaneous settle.
ReplyDelete-- Vance
Thank you Vance, but while concerning I don't think it explains it - in August the problem was with VIX, not SPX. SPX is liquid enough that it can settle in the AM.
ReplyDelete