The VIX is Not Broken

On April the 24th, the Wall Street Journal ran a story detailing the huge move of the VIX index in the opening 30 minutes of trading on the previous Wednesday. The VIX spiked up 12% in 30 minutes despite the underlying S&P 500 index not moving much at all. To put this 12% move into perspective, the current expected move in a 30-minute period is less than 2%. In addition to being a large move, the timing was suspicious. It was during this period that the settlement price for the April VIX futures was calculated. Anyone holding a long futures position would have benefitted greatly, at the expense of the shorts.

There have been rumors about the manipulation of the VIX index for many years. Whether or not the anomalously large S&P 500 option trades during the settlement period are evidence of manipulation, part of an arbitrage or just coincidence, the fact is that the VIX settlement period is often atypically volatile. This is alarming for market-makers and professional arbitrageurs, who claim that the issue will destroy volumes and liquidity. This seems untrue. The issue has always existed, and volumes have only ever increased.

But in any case, for the vast majority of investors the settlement volatility is a complete irrelevancy.

Textbooks usually introduce futures with some story of a farmer who uses futures to lock in a sale price. At expiration he then delivers his product to the counterparty. It is a useful illustrative device, but it is not how most futures are used. Most futures aren’t used as hedging contracts. Most are used for speculation. Depending on the underlying, about 95% of futures aren’t held to expiry. Most people either just trade out of their position or roll the position into a longer-dated contract.

There are stories about traders forgetting to close a futures position and having to take delivery of a train load of hogs or several tons of copper. These are just myths. There is no credible evidence that this ever happened. A few weeks before a future expires, the broker will notify the trader that she holds expiring contracts. For contracts with physical delivery, there is a further chain of procedures designed to prevent accidental deliveries. Most of these steps won’t apply to cash settled contracts like the VIX, but they show that brokers are aware of the problems customers can have with expiring futures contracts. They give traders plenty of warning, and most brokers also accept orders that make them liquidate any contracts close to expiration.

There is nothing factually wrong with the Wall Street Journal article. But don’t let it alarm you. Talton won’t be overwhelmed by a shipment of hogs, and we won’t be holding VIX futures into expiry either.