Recently, I ordered a new book, The Option Trader's Workbook: A Problem-Solving Approach
, thinking that it might be helpful book to review on behalf of subscribers. The book's author is Jeff Augen. I'd heard the book described as a book that presented problems involving the Greeks of option trading, with those problems to be solved by the reader.
The reader who worked through the problems Augen presented would have a better understanding of how options behaved and how options positions could be adjusted, a reviewer suggested. Indeed, the whole book is written as a series of problems to be solved, with information conveyed as the problems are tackled. Near the beginning of the book, I came across a discussion of how liquidity might differ in European-style options and American-style options.
Those unfamiliar with the terms might need a little explanation. According to the CBOE's glossary, a European-style option is an "option contract that may be exercised only during a specified period of time just prior to its expiration." An American-style option can be exercised any time prior to the expiration date. While most broad-based indices such as the SPX and RUT have European-style options, most ETF's have American-style ones. The OEX has both American-style (OEX) and European-style (XEO) options.
It was because of my recent experiences with the XEO that the passage caught my attention. For years, I'd employed XEO options rather than OEX options for my iron condors. My choice had nothing to do with the expiration style. The options I'm selling as part of my iron condors are far out-of-the-money ones, so I'm not worried about whether they'll be exercised. An experienced subscriber had told me that he found better executions on the XEO than the OEX, and I'd tried the XEO for a few cycles and been satisfied with the execution. Beginning this summer, however, I'd had trouble exiting some positions when the markets went wild.
In Question 34, Augen asks, "Can you envision issues related to European-style expiration that could affect liquidity or bid-ask spreads?" Augen's answer suggested the liquidity might suffer and bid-ask spreads might widen during a sudden large move if investors believed that the move might be short-lived. Under those conditions, and knowing that a European-style option can not be exercised except close to expiration, some investors might not be willing to close their positions at a loss, particularly those who had sold calls or puts, Augen opined. Since they're not as willing to close their positions, bids and asks widen. Augen said those who happen to be lucky enough to hold long puts before a sudden sharp downturn might find it difficult to sell their long puts for a fair price, if there's some belief in the markets that the downturn might be soon reversed. These conditions might combine so that those who wanted to close a position during or after a sudden sharp move that is believed to be short lived might find it difficult to close that position.
I wondered if that's what had happened when I had tried to take advantage of a sharp move a few times to close out XEO positions and lock in profit or else had needed to adjust positions over the last few months. We all know how often recent sharp moves have been reversed, sometimes within minutes and sometimes days. However, when I mentioned what I'd read to a former market maker, he didn't believe this could have anything to do with what was happening in the XEO options because of the frequency with which they were traded.
Augen's example did hone in on another underlying that is well known for odd options behavior: the VIX. Several times over the last year (November 21, 2008 Options 101 and July 31, 2009 Options 101), I've addressed the dangers of trading VIX options, and Augen's cautions add another reason to be careful about delving into VIX options. He notes that the liquidity and bid-ask "problem is well-known to investors who trade options on the CBOE Volatility Index (VIX)." These are European-style options. Those who have sold calls on the VIX are reluctant to buy back those calls at a loss when the equities plunge and the VIX rises sharply, he says, if they believe the market move is short-lived.
Augen's explanation doesn't mention the way VIX settlement values are calculated when he answers his own Question 38, but as you may recall from my November 21, 2008 article, VIX settlement values are calculated using a "Special Opening Quotation" or SOQ of the VIX. That's a quotation that's calculated from next-month SPX option series. As Peter Lusk of the CBOE says, providing an example, "November VIX settlement uses December SPX options."
So, in Augen's example, if VIX call sellers believe that a rollover in the equities and the resultant climb in the VIX might be short-lived, not carrying forward into the next month, call sellers might indeed be reluctant to buy back the sold call and lock in a loss. VIX call sellers know that VIX settlement values are calculated based on next-month SPX options, not current ones that might reflect the increased volatilities.
While I haven't experienced or watched this effect myself, it is perhaps another reason to be careful when trading VIX options. Augen says that these factors "ultimately limit the value of out-of-the-money VIX calls as a hedge against a market crash." My former market-marker friend questions whether such liquidity or bid-ask factors show up in other European-style options such as the XEO and SPX options, but I'll certainly be watchful now for stories that either confirm or argue against that effect.