Beware of VIX Option Quirks

Steve Smith Reporter (Options Columnist), Minyanville

It's important to know everything about VIX products, from which contracts are currently available and what the strike prices are to expiration dates and settlement procedure, writes Steve Smith of Minyanville. This article was originally written on the last VIX expiration day of 2012, but its lessons are timeless.

On the last expiration day for options based on the VIX (VIX), we jump right into the deep end with this query from a reader regarding said VIX options.

Steve,

I am following the VXX (VXX) trade, but not exactly. I sold a December $18 VIX put and was just curious to know what will happen if I don't exit the trade by expiration. It doesn't seem to be like other options where you will be required to purchase the underlying stock at the strike price.

The VIX and its related products come with a whole host of idiosyncrasies in terms of pricing behavior, but that is (and has been) the topic for another column.

Let’s just keep the focus on the mechanics of VIX options and how to trade them because they do come with some quirks, such as a special opening settlement price (which I will get to below). Basically, we want to know everything, from which contracts are currently available and what the strike prices are, to the multiplier, to expiration dates and settlement procedure—right down to what the trading hours are when the market is open.

Essentially, we want to know the contract specifications. This is true not only for more complex instruments such as VIX options, but for any security or financial product. Make sure you fully understand the instrument before you invest/trade it.

Here's a quick example to illustrate the fact that quirks can come even in what may appear to be the most plain-vanilla products. The popular SPDR S&P 500 Trust (SPY) pays a quarterly dividend. What many option traders do not realize is that the ex-dividend date is nearly always the third Friday in the month of the quarter, which aligns with the regular option expiration. But this means you must be an owner of record on Thursday to qualify for the dividend. Translation: If you want the payment (which is running around 70c per share, per quarter) you would need to exercise your calls on the Thursday before expiration.

NEXT PAGE: Why VIX Options Are Different |pagebreak|

Many individuals are unaware of this and either fail to exercise their calls or don’t understand why, all else being equal, the value of those calls drops dramatically on Friday morning. Many professionals try to take advantage of this by employing an ex-dividend strategy. I don’t want to digress too much, but you can read about how that blew up on a Bank of America (BAC) trader to the tune of $20 million last quarter, here.

The VIX Is “Different”
Back to the question of whether VIX options are “different” from “regular” equity options. Yes indeed, they are. Like other options based on indexes, the options are cash-settled. This means you don’t have to worry about exercising or being assigned underlying shares. The options have a European exercise, meaning they can only be exercised on expiration. By contrast, most options on stocks have an American exercise, meaning they can be exercised on any business day prior to expiration. Because VIX options are cash-settled, this a technical point. You will simply make or lose money on the trade based on the index’s settlement price on expiration.

And that brings us to two important ways VIX options truly are different from the typical option based on stocks or exchange funds. As noted above, today was the expiration for VIX December futures and the related options. That means yesterday was the last trading day. This is different from the typical third Friday of the month as last trading day and Saturday expiration from standard stock options.

And then there is there is the notorious Special Opening Quotation (SOQ) used to calculate the settlement price on expiration day. It is calculated from the sequence of opening prices of the options used to calculate the index. What this means is that if there is a big opening gap, the settlement price can be very different from the previous day’s closing price. In fact, the settlement can be very different from even the expiration day’s trading range. This morning, which was a pretty tame opening, the VIX SOQ was calculated at 16.68 while the VIX itself spent the first hour trading below 16.45.

As always, be knowledgeable and careful with what you trade.

by Steve Smith, Reporter, Minyanville