A reader asked: “Today (12/04/09), the Dec 27.5 VIX put options had a negative extrinsic value [option price – (strike value – VIX level)] of $-0.36 with bid-ask spread $0.50. Is there something about VIX that makes this situation not abnormal?”
The essential explanation for the apparent pricing abnormality you cite is that VIX options are not priced based on the value of VIX but on the price of VIX futures. For some related discussions, see:
“VIX Options – Predicting The Volatility of Volatility”:
“…since VIX options are a second derivative, standard pricing models based on the old Black-Sholes formula, won’t work the same on VIX options as they do for other options. …the upper and lower tails will be much fatter than for an individual equity. Additionally, since volatility is mean reverting, even when it does spike sharply higher, it isn’t likely to remain there for very long. …To complicate matters further, the CBOE decided to base the price of VIX options not on the current level of the VIX, but on the anticipated level of the VIX at expiration. This means you’ll probably see a closer correlation to the VIX futures on the CFE than to the actual level of the VIX index. In other words, prices for VIX options expiring in the month of May will most closely reflect the level of the June futures contract… Don’t assume that VIX options reflect the current quote of the VIX index. If you do, it can give the appearance that options with farther out expiration dates are “cheaper” than options with nearer expiration dates or that the options are trading at a discount to the intrinsic value, which is not the case. Even more confusing, they expire on the Wednesday that is thirty days prior to the third Friday of the calendar month immediately following the expiring month. For some months this means the expiration date could be prior to the regular equity option expiration and for some months it will be subsequent to the regular equity option expiration.”
“Traders who do not fully understand the relationship between the VIX and VIX option prices were often frustrated when the option prices do not seem to follow the movement of the VIX. After a spike in the level of the VIX, VIX options often appears to be trading at a discount. …because VIX options are european style options, they can only be exercised on expiration date, and so their valuation is based on the expected, or forward, value of the VIX on expiration date, rather than the current, or “spot” VIX value. …unless the expiration date is very near, the market will take into account the mean-reverting nature of the VIX when estimating the forward VIX. Hence, VIX calls seem heavily discounted whenever the VIX spikes. To get a better sense how the market is estimating the forward VIX, options traders can look at the VIX futures price.”
“The most important information to know is that VIX options are not valued based on the VIX index. Instead, the VIX options are valued based on the VIX futures contract.”
