After a lengthy delay, the CBOE announced that $VIX futures will be traded as of February 24, 2006. We first wrote about these options last March (2005) when it seemed that trading was imminent. However, there was a delay -- a delay that is almost over. In this article, we’ll lay out the specifications of the contracts once again and refresh your memories on a few important points about how the contracts might trade.

First and foremost, it should be understood that these are options on the cash $VIX, much as there are options on $SPX or $OEX. These are not options on any of the Volatility or Variance futures.  As a cash-based index option, they can be traded in a regular stock option account with your favorite brokerage firm, just as index options can.

There will be just three expiration months initially -- the two front months, plus the next month on the February cycle (Feb, May, Aug, Nov). So, on February 24, options were expiring in March, April -- the two front months -- and May (the next month on the February cycle). The distance between striking prices will be a minimum of 2-1/2 points. Let’s hope they soon reduce the interval to one point apart.  2-1/2 points is an awfully long way for something relatively stable as $VIX has been in the last few years.

Note: In the original $VIX proposal -- last year -- the underlying index was going to be $VXB, which is $VIX times 100. That is no longer the case, which should help to simplify things for all traders.

There is one important difference between these options and normal stock and index options: They will expire on the Wednesday 30 days before the third Friday of the calendar month immediately following the expiration month. The reason for this is somewhat arcane, but suffice it to say that it has to do with giving the market maker an easier way to hedge his positions as a more or less “pure” arbitrage. Simply stated these options will expire on the Wednesday just before regular options expire or the Wednesday just after.

Based on this, our computation of the option expiration dates for $VIX options this year is shown in the following table:

2006 $VIX Option Expiration Dates

The options will settle with an “a.m.” settlement, as other European style index options (such as $SPX) do. Yes, these are European style options, meaning they cannot be exercised or assigned prior to expiration. Since these options settle on Wednesday morning, the last trading day will be Tuesday -- the day before. 

The same margin rules will apply as index options. Long options are paid for in full, and short options are margined according to the index option formula (option price plus 15 percent of the index value less any out-of-the-money amount, subject to a minimum of 10 percent of the index price).

Readers can find other data on $VIX and $VIX options on the CBOE website at the following link: http://www.cboe.com/micro/vix/vixoptions.aspx

There is historic data there, as well as option quotes (once they start trading, of course).

Option Pricing
The biggest problem many traders are going to have with these contracts is that they will not necessarily trade according to the Black-Scholes model or other conventional option model. This will especially be true if $VIX is very low (below 15, say) or if it is very high (above 35, say). 

The reason for this is that the price movement of $VIX is not lognormal in those areas. For example, $VIX has never traded below 9 -- and rarely has traded at 10 or below. Hence, who is going to buy a put with a 10 strike?  Not many speculators, that’s for sure. In fact, every Tom, Dick and Harry is going to want to sell the 10 puts. So, what is the market maker going to pay for them? Not much.

Conversely, the calls will seem expensive -- according to conventional option models -- because speculators will figure $VIX has a good chance to rise if it’s near 10; the market maker knows that, too, of course, and will adjust the markets upward.

A similar -- but not as extreme -- thing will occur if $VIX gets very high, as it last did in 2002 and early 2003. $VIX could rise to levels higher than it ever has, but it’s likely that there would be a lot of put buyers and call sellers if $VIX got near 35 or 40. Again, the market maker would adjust the market so that the calls seem cheap and the puts expensive, according to the Black-Scholes model.

Is the Black-Scholes model useful at all for $VIX options? It turns out that, yes, it is, for $VIX does behave in a lognormal manner when it’s not near its extremes.

It may seem that $VIX isn’t very volatile, but, in fact it, is. The 100-day volatility oscillates between approximately 50 and 100 percent. There are few, if any, stocks that have a 100-day historical volatility as high as 100 percent. The short-term, 10-day historical volatility of $VIX spikes up above 150 percent at times -- nearly reaching 200 percent last April. Even though $VIX has been trading at low prices for nearly a year, the 100-day historical still maintained a level of approximately 90 percent volatility for much of the year.

While it’s much too early to say exactly how these options will trade, you might see something like this:

Example: $VIX = 11.00

Typical Black-Scholes pricing of 2-month options with 80 percent volatility versus potential $VIX pricing:

Perhaps I’m even too conservative in the $VIX pricing; maybe the call will even trade at a higher price and the put at a lower one. We will only know for sure when real options begin trading.

Strategies
Obviously, these options can be used for speculation, although it may be a little harder than you’d think with the pricing structure being as it is. Speculators have been rather disappointed in the $VIX futures because they have not risen much when $VIX has spiked higher. This is mainly because $VIX futures are priced according to the “strip” of options expiring in that month. 

I really think these $VIX options will be useful to hedgers of stock as well.  Deeply out-of-the-money calls can be bought -- and bought in sufficient quantity -- so as to hedge a portfolio of stocks, should $VIX skyrocket. The cost should be cheaper than trying to hedge with 6-month futures, for example.

If the calls are too expensive, the stock trader could also consider selling $VIX puts, for they too would provide protection if $VIX should spike upward -- just not as much protection.