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By Lawrence G. McMillan

With the current uncertainty in the stock market, the $VIX index has once again received a lot of financial media coverage.  Last week we recommended the purchase of $VIX calls as a hedge for your portfolio.  We received numerous comments from people who took our advice but didn't seem to understand how $VIX options price.  Below is a past Option Strategist Newsletter article from when $VIX options were first listed that explains the basics of VIX options, including a little bit about the pricing.

The following article was taken from The Option Strategist Newsletter Volume 15, No. 6 

The Basics of VIX Options

These options settle, at expiration, at the value of $VIX.  Since they are cash-based options, the difference between the striking price and the price of $VIX (if that difference is positive) becomes a credit in one’s account.  The CBOE has recently received permission to list more expiration months for $VIX options (and for Volatility and Variance futures as well), so that there are currently $VIX options and futures extending out to Feb ‘07.  

Expiration dates are a bit difficult to determine: each month’s expiration date is 30 calendar days prior to the following month’s $SPX options expiration date.  So, for example, April $VIX options expire 30 days prior to the last trading day of regular May $SPX index options. $SPX May options expire on 5/19/06, so April $VIX options expire 30 calendar days prior to that – on April 19th.  As a result of this seemingly arcane procedure, $VIX options always expire on a Wednesday – either the one immediately preceding or the one immediately after regular option expiration.  This expiration date – 30 days prior to the next month’s $SPX option expiration – is necessary in order for market makers and arbitrageurs to be able to establish riskless hedges.  Without the potential for arbitrage, an option market cannot attain large liquidity.

Other than that, $VIX options are very similar to any other index options – calls and puts are listed, a one point move is $100, and various striking prices are offered for both puts and calls (currently, the striking price differentials are 2.5 points, but hopefully approval will be forthcoming fairly soon to reduce that to 1-point differentials).

A fair amount of debate arose as to how to properly price $VIX options, using the Black-Scholes or any other option model.  This is because $VIX trades in a range – rarely going below 10 and (although it’s been several years since it’s been highly priced) rarely going above 45.  Therefore, no one wants to buy the 10 strike puts, for example, and lots of people would want to own calls at that strike.  This relationship seems to be imbedded in the Volatility Futures as well, so a shortcut that seems to be working so far is to price each different month of $VIX options using that month’s futures price as the underlying price – not the price of $VIX itself.  This is a departure from the way that other index options – $SPX, $OEX, $DJX, etc. – are priced.  

You can get delayed VIX futures prices at the CFE website.