The CBOE Volatility Index (VIX) is often called the "fear gauge," because market watchers use it to measure expected volatility over the coming 30 days. According to a recent paper by John Griffin and Amin Shams of the University of Texas at Austin, however, the VIX may reflect something besides fear: the authors' findings suggest that traders have their finger on the scale.

The VIX works by tracking the implied volatility of a range of S&P 500 index options. Since traders buy and sell these options in order to hedge against or profit from future moves in the market, the options' implied volatility indicates the turbulence that traders expect—if not necessarily the turbulence they get. (For more, see also: Strategies to Trade Volatility Effectively With VIX.)

Griffin and Shams hypothesize that the VIX's mechanics leave it open to manipulation. Say you have a long position in VIX futures. If you're willing to get your hands dirty to ensure a profit, you can submit "aggressive" buy orders for S&P 500 options during the pre-open auction period—7:30 to 8:15 a.m. CST—driving up the index options' clearing prices and with them the VIX.

According to the authors, this scenario is not just hypothetical. On settlement days for VIX derivatives contracts—at least in months when the VIX gains significantly— the price of S&P options has tended to rise until 8:15, suggesting they are being bid up in attempt to inflate the VIX. The price then tends to list back downward for the final 15 minutes before settlement, when trading is only allowed in options unrelated to open VIX positions. This movement indicates that "other traders put in orders to sell the overpriced options and adjust the prices downward. However, the prices are not fully reversed, and we observe more downward adjustment from settlement to open."

Images sourced from Griffin and Shams.

Other "interesting" patterns emerge. For example, most options see increases in trading volume as expiration approaches. Not so with S&P 500 options, for which trading volume spikes exactly 30 days prior to expiration. "This is not due to any kind of obvious S&P 500 market-related event," the authors write, "but it is the date that the VIX settles." The authors also find that the spike in trading occurs only in out-of-the-money options, which factor into the VIX's calculation. In-the-money options, which don't affect the VIX, barely budge. (For more, see also: What Is Option Moneyness?)

The authors explore two alternative explanations, hedging and pent-up demand for liquidity, but conclude that these do not explain the patterns they see in the trading data.

The Chicago Board Options Exchange (CBOE), which owns the VIX, emailed a statement to Investopedia saying that Griffin and Shams' work is based on "fundamental misunderstandings" of the index's mechanics. Patterns suggestive of manipulation are "entirely consistent with normal and legitimate trading behavior," the statement said, and the paper's authors are not privy to all relevant data. "CBOE takes seriously any market abuse, including manipulation of the VIX settlement process," the statement added, "and maintains a regulatory program that surveils for violative activity, and takes appropriate disciplinary action when warranted." A CBOE spokeswoman told Investopedia that the exchange has never taken disciplinary action against a party for manipulating the VIX.

In an email to Investopedia, Griffin and Shams wrote, "Contrary to CBOE's assertions, we have studied the VIX settlement thoroughly, presented our paper widely, and have talked to various trading professionals who corroborate our understanding of the settlement process and findings." They called on the CBOE to release any data "they think would be useful to better understand and design the settlement" to academics, "as is commonly done with other exchanges." They expressed surprise at the CBOE's "apparent defensive posture" and said it was "disappointing that CBOE doesn't seem concerned that settlement deviations are extremely costly to the investors using their products."  

In a Bloomberg column, Matt Levine put forward another, more "innocent" explanation for the apparent manipulation: traders taking cash delivery when their VIX derivatives expire (since physical delivery of volatility is impossible) and using it to purchase the underlying S&P 500 options so as to maintain similar volatility exposure. "We do test that possibility as one our hedging hypotheses in the paper," Griffin told Investopedia. "We discuss it and rule it out as a complete explanation." 

The iPath S&P 500 VIX Short-Term Futures ETN (VXX), just one of many VIX-linked exchange-traded products, has nearly $930 million in assets, according to The Wall Street Journal cites an estimate by Macro Risk Advisors that around $30 billion is tied to VIX derivatives. (For more, see also: Low Volatility: The Calm Before the Storm.)

Writing to Investopedia, Griffin and Shams likened potential manipulation of the VIX to past scandals surrounding LIBOR​, gold, silver and the foreign exchange market, "all of which were obviously gamed." (For more, see also: The LIBOR Scandal.)

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