VIX Settlement: Risk Inherent in the Settlement Procedure

The Final Settlement Value of each Volatility Index Futures and security contract is calculated from the actual opening premium prices on CBOE of the Constituent Options on the Final Settlement Date, unless there is no opening trade in a series, in which case the mid-point of the bid and offer premium quotations for that series as determined at the opening of trading is used. In contrast, all other Volatility Index values disseminated during the life of a Volatility Index futures or security futures contracts are “indicative” values – namely, values that are calculated using the mid-point of the disseminated bid and offer premium quotations on CBOE of each of the Constituent Options at a particular time.

Because actual prices are used to compute the Final Settlement Value of Volatility Index futures and security futures while mid-market options quotes are used to compute indicative Volatility Index values, there is an inherent risk of a significant disparity between the Final Settlement Value of an expiring Volatility Index futures or security futures contract and the opening indicative Volatility Index value on settlement value on the Final Settlement Date. It is to be expected that there will be at least some divergence between the Final Settlement Value for an expiring Volatility Index futures or security futures contract and the opening indicative Volatility Index value on Final Settlement Date, because the opening price for each of the options series that is used to calculate the Final Settlement Value will typically be at or near either the bid or the ask quotation, depending on the forces of supply and demand for that series, and not at the mid=point between the bid and ask quotations. In fact, such disparities have occurred in the past with respect to VIX and other Volatility Index futures contracts. Accordingly, because Volatility Index futures and security futures settle based on the trade prices of the Constituent Options established during the opening, rather than on quotes, investors should be aware that the possibility exists, as occurred in the past, that there could be a significant difference between the Final Settlement Value for a Volatility Index futures or security futures contract and the previous days closing indicative Volatility Index value, or the opening indicative Volatility Index value on the Final Settlement Date.

For example, one type of hedge for VIX futures involves holding a portfolio of the SPX options that will be used to calculate VIX on the Final Settlement Date. Traders holding hedged VIX futures positions to settlement can be expected to trade out of their SPX options on that date. Traders who hold short, hedged VIX futures would liquidate that hedge by selling their SPX options, while traders holding long, hedged VIX positions would liquidate their hedge by buying SPX options. In order to seek convergence with the VIX Final Settlement Value, these traders would be expected to liquidate their hedges by submitting orders in the appropriate SPX option series during the SPX opening on the Final Settlement Date of the VIX futures contract. To the extent (1) traders who are liquidation hedges predominately are on one side of the market (e.g., seek to buy the particular SPX options) and (2) those traders’ orders predominate over other orders during the SPX opening on the Final Settlement Date for the VIX futures contract, trades to liquidate hedges may contribute to an order imbalance during the SPX opening on that date. If there are order imbalances significantly weighted on the same side of the market in SPX option series used in the final settlement, there will be a disparity between the Final Settlement Value and the VIX index values that are reported after the SPX opening. In fact, these factors did occur, and did lead to this type of imbalance and disparity during past SPX openings for VIX futures settlement days. The same is equally applicable with respect to other Volatility Index futures and security futures.

In order to avoid exposure to such disparities, investors in Volatility Index futures and security futures holding speculative or un-hedged Volatility Index futures or security futures may wish to either close out their positions or roll to another contract month prior to settlement. Market participants should consult their CFE Trading Privilege Holder (TPH) for specific roll market information.

Volatility Index security futures investors should refer to the Risk Disclosure Statement for Security Futures Contracts for further security futures risk disclosure information.

Additional information can be found at https://www.cboe.org/publish/RegCir/RG08-042.pdf and http://cfe.cboe.com/framed/PDFframed.aspx?content=/publish/CFEinfocirc/CFEIC12-004.pdf&section=SEC_ABOUT_CFE&title=CBOE%20%E2%80%93%20CBOE