Some of you have asked me to discuss volatility options. The CBOE Volatility Index (symbol: VIX) measures the volatility implied on a series of 30 day at-the-money and near-the-money options on the S&P 500 index.

Of course, a 30 day option only exists once a month; on the Wednesday that is exactly 30 days prior to the third Friday of the following calendar month. That raises two points that differentiate VIX options from all other option contracts; 1) VIX options expire on the Wednesday that is exactly 30 days prior to the third Friday of the following month (Expiration dates for VIX options are available at the CBOE Web site www.cboe.com) and 2) VIX options are always pricing volatility 30 days forward.

In order to calculate VIX on days that do not fall on the Wednesday expiry, CBOE calculates “a weighted average of options expiring on two different dates.” This is referred to as the “term structure” of VIX options. That’s important, because unlike equity and index options where the price of the underlying security is a given, volatility can be skewed across different option series.

The term structure also means that VIX options are less sensitive to time value. For example, the VIX closed on Friday at 56.10. The VIX November 50 calls (expiry date Nov 19th) closed on Friday at US $7.60. At the same time, the VIX January 50 calls were trading at US $5.60.

Another reason underlying this unique pricing model is that VIX prices do not reflect a lognormal distribution. With an equity option, we know that the underlying security cannot fall below zero, and could theoretically, rise to infinity. A lognormal distribution is the best, albeit, imperfect fit for that type of price movement.

VIX on the other hand, can never go to zero, because that would imply that there would be no change in the value of the S&P 500 index. Similarly, persistently high VIX readings are unlikely, because there would have to be an expectation of very large daily price changes in the S&P 500 index.

Because of that, volatility fits better within a “mean reverting” distribution. Which is to say, at extreme volatility readings, there is a higher probability that the next move in the VIX will be in the opposite direction.

What makes the current environment so interesting, is that we have been in a period of heightened volatility for more than a month. Statistically, that is an off-the-scale anomaly. And, I might add, the reason so many of my past comments have focused on option writing strategies.