On the morning of December 20th, we noted that VIX crashed at the open of the cash market.
VIX crashed to 8.90 as cash markets opened…
In context of the prior and following days, it was an ‘odd’ gap down move that was immediately defended by most as “just a fat finger” except it wasn’t and it was critical to the settlement price as billions of VIX futures were set to expire.
This was certainly not the first time that VIX had flash-crashed at an ‘opportune time’ for the near-record short speculative VIX futures positioning.
But, as Bloomberg reports, it reignited claims that VIX was yet another manipulated market that had been highlighted by a critical academic study we detailed here.
While the CBOE has seen nothing to alter its view that the claims are baseless, December’s events gave the conversation another stir.
“There couldn’t have been a more appropriate cherry on top of the 2017 cake,” said Patrick Hennessy, head trader at IPS Strategic Capital in Denver. “The VIX settlement in December was one for the books.”
However, criticism (or skepticism) of the settlement process left the realm of the acadmeic and theoretical last week when its futures exchange fined a Chicago-based trading firm following allegations it submitted improper bids to volatility auctions on emerging-market stocks and oil.
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CBOE gets an official settlement level of the VIX based on a special monthly settlement auction of S&P 500 options. The auction runs from 7:30 a.m to 8:30 a.m., Chicago time. Traders submit bids and offers for S&P 500 options, the auction matches buyers and sellers to find clearing prices, and the prices of those S&P 500 options are used to compute the official settlement level of the VIX.
At the settlement time of the VIX Volatility Index, volume spikes on S&P 500 Index (SPX) options, but only in out-of-the-money options that are used to calculate the VIX, and more so for options with a higher and discontinuous influence on VIX.
We investigate alternative explanations of hedging and coordinated liquidity trading. Tests including those utilizing differences in put and call options, open interest around the settlement, and a similar volatility contract with an entirely different settlement procedure in Europe are inconsistent with these explanations but consistent with market manipulation.
That’s from this paper by John Griffin and Amin Shams of the University of Texas, who find a lot of trading in the S&P 500 options underlying the VIX during these settlement auctions, trading that pushes the settlement price of the VIX up or down. So for instance in months where the trading pushes the VIX up, the prevailing price of the VIX-influencing options will jump during the auction, peak at around 8:15 a.m. (the deadline for VIX-related bids in the auction), and then drop seconds after the auction ends when the options start trading normally:
The blue line there is a measure of the indicative prices of VIX-influencing options, spiking at 8:00 a.m. and peaking near 8:15. (If you ignore the numbers on the axis, you can almost think of it as being a chart of the VIX price.) The red dot is the trading price of those options about 25 seconds after the auction finishes.
The average effect is something like 0.31 VIX points, sometimes up and sometimes down, depending on the month.
What is going on? Usually when you see patterns like this, the innocent explanation is hedging. But Griffin and Shams consider and reject that notion here, noting for instance that traders don’t seem to be closing out existing hedge positions but instead adding new ones. They argue that it’s more likely to be explained by attempts to move the VIX: If you are a dealer who is long (short) VIX futures, you can push up (down) the VIX at settlement by buying (selling) some deep-out-of-the-money S&P 500 options.
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And that brings us back to the real-world.
As Bloomberg reports, exchange officials say nothing untoward is going on, that the VIX settlement repels tampering through a transparent auction process that is separate and distinct from its pricing the rest of the day. And conversations with a half dozen options professionals show that while the topic is hotly discussed, many reject claims of overt manipulation.
But the events of Dec. 20 are familiar enough that questions keep coming back. Why does the VIX, a reference value for futures whose final price is set in an auction by the Cboe, often settle so far away from its market price?
Bloomberg data show that of the 10 biggest gaps between the VIX settlement value and its closing level the night before, five came in 2017, including December’s, which was the biggest discount in 11 years.
On monthly expirations, settlement occurred outside the VIX’s same-day trading range 42 percent of the time last year, the most since 2005. The average occurrence was 15 percent in the decade through 2016.
While a lot of innocent explanations exist, “really, it is a mystery,” said Pravit Chintawongvanich,the head of derivatives strategy for Macro Risk Advisors.
“Some people rightly get confused about why the settle is seemingly out of context with the market.”
As we concluded previously, there is a sort of hierarchy of manipulability in markets.
At the top is Libor manipulation: Trillions of dollars of derivatives settled based on Libor, but Libor was calculated by essentially asking banks “what should Libor be?” The banks didn’t even have to do any trading in order to push the number around; manipulation was, in effect, costless. (Later, with the fines, it was costly.)
At the bottom is, for instance, manipulating the price of a stock by trading that stock. There are cases of it! It’s a thing. But it is a dumb thing; it really shouldn’t work. If you buy a stock, you will push the price up, sure. But to make any money you then have to sell the stock, which should push the price right back down.
But if you are going to manipulate a tradable market — as opposed to a made-up one like Libor — then VIX looks pretty tempting.
The product that you trade (S&P 500 options) is different from the product where you make your money (VIX futures and options), and the trading market is in the relevant sense smaller than the derivative market: You can move a lot of value in VIX products by trading a small amount of value, in a confined period of time, in the underlying market. So you can cheerfully lose money executing the manipulation — trading the S&P options — and make back more in the derivative.
If Griffin and Shams are right that there’s manipulation – which the real-world data suggests – there’s no particular pattern to it: Sometimes VIX gets anomalously pushed up during the settlement, sometimes down.
That’s consistent with, for instance, a story of big dealers adding up their positions before each monthly settlement, realizing that they’re net long (short), and trying to push VIX up (down) to help out their positions. It would be like the kind of Libor manipulation that banks did to help out their trading books (which was up or down depending on their positions) — not the kind of Libor manipulation that banks also did to disguise their funding costs (which moved Libor systematically down).
Finally, The Wall Street Journal noted that it is, of course, tough to rule out the possibility that something more benign is going on. For example, investors who had used the expiring derivatives to protect themselves could be seeking replacement protection when they participate in the auction, some say.
However, Messrs. Griffin and Shams believe it’s not hedging activity due to the trading patterns they observed.
Hennessy of IPS says in a market dominated by professionals, everyone plays at his own risk.
“Like any market it is susceptible to manipulation by large participants but I think that most VIX traders understand that,” he said.
“2017 saw many settlements that came in points away from the previous day’s close value, and at this point you have to understand the risk you are taking on if you choose to let your options/futures position go into settlement.”