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June 19, 2017, 2:07 p.m. EDT

How S&P 500 options may be used to manipulate VIX ‘fear gauge’

Some $1.8 billion may have been transferred through VIX manipulation, study finds

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By Elliot Blair Smith, MarketWatch

Getty Images
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 /zigman2/quotes/210598281/delayed VIX -9.14%  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. /zigman2/quotes/208166986/composite CBOE -0.45%  , 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.”

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