Strange volume in the S&P 500 Index (SPX) August puts yesterday, integral

Strange volume in the S&P 500 Index (SPX) August puts yesterday, yowza. With the index in the 1,680 range, 29,000 of the August 1300 puts traded, 39,632 of the August 1250 puts traded, and 17,933 of the August 1200 puts traded. In fact, every put in the August series down to 1115 traded on the open. Even the August 500 puts traded!

What in the world is going on here? Did someone get a fake copy of Bernanke's Humphrey-Hawkins prepared remarks?

OK, no, I'm being intentionally clueless (as opposed to times my cluelessness gets unintentional). There's an easy explanation for all this volume, and it has nothing to do with directional opinions in the markets.

It was July expiration for the CBOE Volatility Index (VIX). All VIX July futures and options cashed out on the VIX settlement price. Remember always that all VIX futures and options cash-settle; there is never delivery of any securities.

And how do we determine this VIX settlement price? I'm glad you asked. This, from the CBOE:

The Final Settlement Price for VIX Futures is determined from a Special Opening Quotation (SOQ) of VIX. The SOQ is calculated from the sequence of opening prices of the SPX options used to calculate the VIX index on the settlement date (the "Constituent Options"). The opening prices for SPX options used in calculating the SOQ are determined through an automated auction mechanism ("Hybrid Opening System" or "HOSS") that matches buy and sell orders residing on the Electronic Order Book prior to the opening of trading. If there is no opening price for a Constituent Option, the average of that option's bid price and ask price as determined at the opening of trading is used instead. The settlement date for VIX futures is the Wednesday that is thirty days prior to the third Friday of the calendar month immediately following the month in which the contract expires ("Final Settlement Date"). The VIX White Paper provides specific information on the VIX calculation.

In (sort of) plain English, the settlement price in VIX is NOT the first VIX price you see on the board on expiration day. Rather, it's a calculation based on all the constituent series in the SPX. And that currently includes no July SPX options, as the VIX calculation does not consider any SPX options within eight days of expiration. Thus, the VIX is basically a volatility index of August SPX options, normalized to 30 days' duration.

But not every August option! VIX stops including them once two consecutive series of options do not trade. So in other words, if there's no volume in the August 1505 puts or the 1500 puts, then VIX will not consider any strikes below 1510 (assuming that's the lowest qualifying strike).

And on a normal day, the last qualifying series is a relatively "normal," i.e., one with some value. On VIX expiration day, however, orders magically appear at pretty much every strike.

Why? The buyer is essentially doing an arb. The strip of options he buys serves to affect the VIX settlement price as all these options now play into the VIX settlement price. On the flip side, he's spent some cash on completely worthless options that will likely never trade again and he's presumably rolled into the August VIX.

There's also a "seller" doing the opposite in every which way, so it's effectively a complicated crossed transaction.

And I suppose it all comes out. This same play has been executed every expiration since the beginning of VIX time. Theoretically, you the trader/investor can participate. You can offer worthless way-out-of-the-money puts and try to get in the way of the cross. Whether they let you in without a fight is unclear, but legally they have to come to market and actually cross the trade.

Disclaimer: The views represented on this blog are those of the individual author only, and do not necessarily represent the views of Schaeffer's Investment Research.