Breaking Down the 'Loud' VIX

Speaking of volatility of volatility, check out how the CBOE Volatility Index (VIX) looked on Monday, via CNBC:

There's a simple explanation, of course, and it didn't involve fat fingers or major publications somehow believing a high school kid could earn $72 million out of the trading ether.

Yep, it was just good old-fashioned bad quotes!

The Chicago Board Options Exchange (CBOE) calculates the VIX via quotes in qualified S&P 500 Index (SPX) options. Thus, if an SPX option has an inaccurate quote, it can cause the VIX to "print" an inaccurate number. Multiply that by a lot of quotes and you get a VIX that will produce some odd numbers. And that's exactly what happened.

The issue, according to the CBOE, derives from the way the VIX equation collects options quotes. The CBOE takes the bid and ask price of every option (that is, the price at which market makers are willing to buy and sell each option, respectively) and finds the average. For instance, if the bid price is $0.10 and the ask price is $0.30, the "true" option price will be considered to be $0.20. However, what began to happen was that the bid/ask spreads on those S&P options started to widen vociferously and sporadically. Generally, the ask price was rising, while the bid price stayed the same.

Quotes went from $0.10 wide to $2 wide -- and then back again. This has the effect of lifting the midpoint of the quote up $0.95, and then back, and then up again, and so on. Thus, the rather loud VIX. As a general rule, by the way, if you ever see VIX doing that, assume it's some sort of mechanical error and not risk tolerance/aversion going up and back by the minutes.

Yes, it's possible that quotes go wide in a blink. We used to call it "fast market." It was a euphemism for "the quotes on the screen aren't right. If you really want to make a trade, you'll do it at my price." With everything automated now, you don't have the luxury of trading at different prices than you see, so systems are programmed to just quote everything super wide to begin with at times of market stress. But, the market wasn't all that stressed. Apparently, someone thought otherwise and kept going to wide markets. And then here's the part that kind of surprised me, from the aforementioned CNBC article:

"The reason the error would not have been limited to a single firm is that the four major firms that provide quotes for monthly S&P options follow each other closely, with the help of computer algorithms. If one firm pulls or hikes its ask price, the other firms' systems will not immediately be aware that it is due to an error, and will thus follow the ask price higher, according to former VIX market maker Brian Stutland."

In other words, if there's a glitch in one algo, the other algos see the resulting quotes and default to "find a human to trade with." Yeah, liquidity!

Good to know that four-and-a-half years after the flash crash there's about a 100% chance it could easily happen again. I hope I'm wrong on this, but it suggests that all we need is one firm going to wide markets at the same time there's a sell program going on and look out below!

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.