Pedestrians walk by the Chicago Board of Options Exchange (CBOE) building on February 11, 2011 in Chicago, Illinois.
Are traders manipulating options tied to the Standard and Poor’s 500 to inflate the settlement value of a popular volatility index known as the VIX—and skimming profits?
No, says the Chicago Board Options Exchange, which recently reported a fourth consecutive year of record index trading, posting new highs in SPX options and VIX futures.
But some investors and financial academics—and even one of the VIX’s VIX, +1.06% designers—say heavily traded VIX derivatives are vulnerable to an index settlement mechanism calculated once a month from underlying SPX options that are less liquid.
Widely described as the “fear gauge,” the Chicago Board Options Exchange Volatility Index attempts to capture market expectations about future stock-price volatility.
Any challenge to the index’s integrity has the potential to undermine market faith in $30 billion of related hedging contracts, and erode the profitability of exchange parent CBOE Holdings Inc. CBOE, +0.87% , a financial products innovator whose stock has risen 40% over the past year.
John Griffin, a University of Texas finance professor, and Ph.D. candidate Amin Shams say the cost of manipulating less-liquid SPX options could be more than compensated for with a bet on the direction of the VIX. And they contend that distortionary SPX prices might have generated “a sizeable wealth transfer” from investors on one side of VIX derivatives trades to the other, conservatively amounting to $1.81 billion between January 2008 and April 2015.
CBOE officials say the VIX is a transparent, closely regulated, and highly reliable gauge of market sentiment with no history of failure.
A team of Goldman Sachs & Co. quantitative analysts led by Emanuel Derman—now a professor of financial engineering at Columbia University—began developing the idea of volatility as a financial asset in the late 1990s. Early last decade, three other Goldman Sachs investment professionals developed the formula the CBOE began quoting as the VIX, and on which tradable futures and options were introduced in 2004 and 2006.
These products can be used to hedge—or speculate on—a range of products from credit rates to currency and commodities. Since then, the CBOE has created other volatility measures tracking gold, silver, crude oil, and even Apple, Google, Goldman Sachs, and China.
SPX options used to calculate the VIX settlement are selected from a range of out-of-the money SPX put and call options. “Out of the money” refers to a call option with a strike price higher, or a put option with a strike price lower, than the market value of the underlying asset.
These options expire 30 days in the future, meaning the VIX is designed to capture the expected volatility of the S&P 500 equity index over the coming month.
The settlement itself is based on an auction called the “special opening quotation,” or SOQ, which occurs on the third or fourth Wednesday of each month, between 7 a.m. and 8:30 a.m. Often times the settlement varies significantly from the VIX’s closing price the prior evening, and the opening price that same morning.
While risk sentiment sometimes shifts overnight—think of evening political developments in Washington, and early-morning economic news from Asia and Europe—traders such as Bill Luby of Luby Asset Management in the San Francisco Bay area express concern when the VIX settlement varies significantly from the opening price.
“Any time I see a SOQ that is more than 3% or 4% above the opening price, that to me sends a red flag,” Luby says. He provided me with a historical spreadsheet on VIX settlement prices, and said the increased “frequency and magnitude of the extreme outliers” from opening and closing prices since about November 2016 “has caught my attention.”
The Griffin and Shams analysis examines whether a “strategic manipulator” could profit by taking a position on the VIX, and then submitting aggressive orders for out-of-the-money SPX options that are used to calculate the index during settlement.
The evidence from January 2008 to April 2015 shows that “in days with large positive” deviations in the VIX settlement “the average indicative SPX price starts low” before the market opens, and creeps upward from 7:45 a.m. to 8:15 a.m. Designated market makers take over at 8:15 a.m. (now 8:20 a.m.), at which point prices typically go down, Griffin and Shams say.
However, they say, “aggressive orders before 8:15 a.m. still leave a significant effect on the settlement prices at 8:30 a.m., even after prices are partially corrected.”
A slight, temporary bump in the VIX is all that’s required to skew cash-settled derivative contracts, and would leave only the slightest trace in exchange records.
Griffin and Shams dug deeper to see if they could find evidence to support their hypothesis, and—although the CBOE disputes their finding—they think they did.
“First, at the exact time of monthly VIX settlement, highly statistically and economically significant trading volume spikes occur in the underlying SPX options,” Griffin and Shams write.
“Second, the spike occurs only in the (out-of-the-money) SPX options that are included in the VIX settlement calculation and not in the excluded in-the-month SPX options,” the academics contend. “Third, there is no spike in volume for the similar S&P 100 Index or SPDR S&P 500 ETF options that are unconnected to volatility index derivatives.”
CBOE Vice President of Research William Speth says Griffin “overlooks that traders legitimately seek to replicate VIX futures and options that will expire at final settlement, and to do so those traders logically will need to trade in the very options that Professor Griffin found, and in the same quantities and at the same point in time that Professor Griffin observed.”
Griffin told me he took those factors into account, and that “if the CBOE has more detailed data that they think would be useful to better understand and design the settlement, they should release such data to the public.”
Trading patterns in the European volatility index known as VSTOXX V2TX, -5.18% are consistent with efforts to manipulate it also, Griffin and Shams say, although VSTOXX has a different settlement procedure. It’s calculated as the average of index values (captured at five-second intervals) between 11:30 a.m. and noon on the closing date, making it potentially more difficult to distort.
Manipulative trading in VSTOXX would have to be sustained for a half-hour, and optimally would occur every five seconds, Griffin and Shams state.
They examined VSTOXX settlement windows in increments of 100 milliseconds (one-tenth of a second), and discovered that settlement trades “clustered nearly exactly at five-second intervals” during the settlement period, but at no other point during the day.
Further, they found concentrated trading in inexpensive out-of-the-money options at the cutoff for consideration in settlement. Small price changes in the options could lead to them being included, or excluded, from the calculation. Trading volume in these options was about 130 times greater during settlement than in the rest of the day, the academics found.
A spokesman for the Deutsche Borse Group DB1, +2.49% in Frankfurt, which created VSTOXX, did not provide comment in response to my questions.
I also reached out to Timothy Klassen, the chief executive of Volar Technologies, a New York firm that develops analytics for options trading, and who was a member of the Goldman Sachs team in 2003 that designed the VIX index the CBOE subsequently adopted.
Klassen told me he was aware of the vulnerability of the VIX settlement to potential manipulation, though he pointed out it “is harder in liquid markets,” and that “trying to manipulate the VIX is not conceptually different from trying to manipulate any other index product” that is dependent on underlying financial contracts or securities.
The CBOE itself seems to have been concerned since at least March 2008, when it issued a regulatory circular stating that traders submitting orders ahead of the VIX settlement “may not do so for the purpose of creating or inducing a false, misleading, or artificial appearance of activity or for the purpose of unduly or improperly influencing the opening price or settlement or for the purpose of making a price which does not reflect the true state of the market.”
CBOE spokeswoman Suzanne Cosgrove told me, “There are numerous structural safeguards built into the VIX settlement that make it difficult to manipulate, and our regulatory group actively surveils for potential VIX settlement manipulation.” Cosgrove also said: “CBOE has not made any regulatory findings that the VIX final settlement has been manipulated.”
In one other on-the-record comment, CBOE Vice President of Research Speth said: “Professor Griffin does not conclude that there has been manipulation of the VIX settlement, but rather just that it supposedly is susceptible to manipulation.”
Klassen himself says the VIX settlement process “almost certainly could be relatively easily improved.” He adds: “I don’t think any of the CBOE’s clients would be opposed to improvement to avoid manipulation.” None, that is, except possibly for a manipulator.