Tomorrow, options on Chicago Board Options Exchange Market Volatility Index (VIX) futures expire. Some traders use these options to speculate on the direction volatility, but many fund managers, with two bear markets and a “flash crash” fresh on their minds, utilize call strategies on the VIX to hedge long positions and protect against tail risk.
Today is the last day that January expiration options can be traded andwe will see another post-expiration drop-off in VIX call open interest. Per the first chart below, courtesy of TradeAlert, VIX call open interest is only a chip shot from record levels heading into this morning’s trading.
Given that some portfolio hedges will expire tomorrow morning, fund managers will be anxious to replace portfolio insurance that has expired. Our theory is that major VIX call buying, which tends to occur in the days immediately following VIX expiration, is a coincidental headwind for the equity market, as those selling volatility to those seeking portfolio insurance will hedge via shorting S&P 500 Index (SPX) futures.
Therefore, it is appropriate to update the study that we produced last month, the day of VIX expiration. In this study, we compare the expiration-week returns from Tuesday’s close (the last day front-month VIX futures options can be traded) through the Friday close in the weeks that VIX futures expire during expiration week, with the expiration-week returns from Tuesday’s close through Friday’s close in the expiration weeks that VIX options do not expire (sometimes VIX options expire the Wednesday after expiration week).
The data we observed is since 2010, when VIX options began growing in popularity. As you can see on the table below the graph, the S&P’s performance is weaker from Tuesday through Friday during instances when VIX options expire during expiration week versus expiration weeks when VIX options do not expire. This supports the theory that the market faces potential headwinds due to the expiration of VIX options. For what it is worth, the SPX declined 1.2-percent from Tuesday’s close to Friday’s close during December expiration week, when VIX futures options expired during the week.
The one thing that bulls might find encouraging is that only 43 percent of overall VIX open interest is in the January series, which is an unusually small percentage. Usually, the front month options make up closer to 50 percent of outstanding VIX open interest. The implication of this is that the usual rush to buy VIX calls may be dampened relative to the past, since many have viewed the spike lower in VIX futures to buy February and March expiration calls at a blistering pace the past couple of weeks. In other words, there is a chance that the ramp-up in call buying post expiration may not be as great.
VIX – call open interest near record levels ahead of expiration tomorrow – note that VIX rallies have tended to occur after VIX expirations, when call open interest is relatively low
SPX expiration-week performance poor during weeks that VIX options also expire