This is not true. The determining factor for early exercise of an American option is the value one gets from receiving cash today at time t vs at expiration at time T. If one can earn interest on the cash received from period t to T, then there is a benefit from early exercise. This does not include just dividends. For example, deep in the money options on futures will have a cash flow benefit from the release of variation margin which will earn interest from t to T.
ok this is getting weird - all I said there was that it was not clear from the original post that the strategy the OP put forward was to use low VIX as an indicator to buy long term (non VIX) options. This is not a 'way to look at options'. @Martinghoul: As regards the value of European vs. American options : https://en.wikipedia.org/wiki/Option_style#Difference_in_value In summary - if there are circumstances in which it is advantageous to exercise early then the American options should be more expensive than the European one. An American style option should never be cheaper than a European one but it can be more expensive, most notably for puts but not only puts. A number of circumstances are listed in the Wiki page and everyone knows the issue with dividend bearing stocks. There are also special cases where the the interest value of the money obtained from exercising a put will exceed the theta value of option. Hence the statement that European and American options should be priced identically based on theory is false. However even that is not what I was referring to - Black & Scholes is an approximation of price in particular for American style options. Therefore I was referring to real market action not the theory which guides the market. Depending on the price variations of the underlying an option's bid/ask spread will grow - this is temporary. VIX options specifically have an issue that at moments of spikes in the VIX, the spread will grow and prevent you from getting the benefit of your long VIX call position. This is not exclusive to the VIX insofar as stocks options of lower liquidity post earnings can also display this behaviour and sometimes your only remedy is to exercise because the bid price for your option is dreadful. If you were able to exercise VIX options this spread could not occur because it could be circumvented by the exercise that would force the seller to shell out the full market value. In the case of less liquid stock options it is usually enough to wait a little while - though sometimes this can take more than a day - and the bid/ask spread will close. In the case of the VIX however such a wait can be exceedingly punishing because it may move back to the mean as fast as it spiked up. In summary at such a moment there would be value in having an American style VIX option and therefore this is a significant difference.
So just to be clear we're now engaging in a more esoteric discussion, I think we all agree the naive view I was responding to was completely incorrect? I agree that "The determining factor for early exercise of an American option is the value one gets from receiving cash today at time t vs at expiration at time T." is entirely correct. I'd maintain that dividends are generally the reason that this is true in practice at least right now. At today's interest rates you'd need to be very deep ITM on a very long duration option with almost zero volatility for interest to exceed the value of the remaining volatility, although certainly a case exists where this would be true.
The absolute level of rates is not important as to whether you should exercise. Sure, higher rates equates to more money. But to a bank that has a 100 million dollar position, if the net benefit is > 0 then they should exercise. Also, you want less time, not more. The more time you add, the "further" in the money the option will need to be. So usually this is a process that will happen with less time vs more time. This of course not really related to the OP. I'm just being anal correcting your previous post. When I was taking my derivatives class in grad school, that comment would have gotten me an F in the course. LOL.
Well you're learning, which is good! We all agree that "if they were european style exercise and the market expected the price to come down prior to expiration, then the price of the option may not move much if at all -- and this is the primary issue with VIX options timing." is nonsense. Now you're bringing up an entirely different issue, which is a bid ask spread that is so large that it completely overwhelms the extrinsic value of the option. If such a thing ever happens in practice, put a bid/ask in for a few cents above intrinsic and give me a call, I'll hit that every damn time! As will any professional, which is why it's largely an imaginary situation except in some unique circumstances like a hard to short stock. Bonus question for you, why is your circumstance completely implausible with regard to a "less liquid stock option" but potentially somewhat plausible with VIX?
Sig, there is no need to be patronising - you are not reading me correctly I am afraid. I never made the contrary point to your first one at all. I brought up two points including the spread, I take note of the offer to nail the intrinsic value. Let me just say that is not what happens in my no doubt very limited experience nor what I gleaned from the books I referenced. On the illiquid stock vs. VIX - again you have not read what I wrote correctly. Both things happen - it tends to be more punishing with the VIX simply because when there is a spike it can be very volatile indeed. An illiquid stock gaping up or down will also settle back a bit but you are usually left with some meat on the bone. I rarely venture into the VIX except on the short put side as hedge against a market move down - on illiquid stocks I had my fair share of being burnt - well singed - due a sudden liquidity spread occurring when the stock makes a move the market makers didnt like. In the VIX the liquidity is such that the bid/ask spread must be a consequence of the supply and demand IMHO.
Sorry, I'm not being condescending at all. You're simply incorrect and I'm trying to be educational and helpful instead of telling you that you're a moron who doesn't know what the fuck he's talking about. If you'd like me to shift to that I certainly could, but I think you're honestly learning here and that's great. Absent an edge case like a dividend or hard to borrow short situation, or as Mav pointed out a long dated futures with interest factors option, you'll always, always be able to sell a european option for at least intrinsic. Anyone, including you, can enter into a risk free arb with a synthetic replication of the option and capture the volatility upside for free. I'll be happy to pay you $1,000 tomorrow if you can show me a resting offer for less than intrinsic that wasn't hit on any stock, again absent an edge cases. It simply doesn't exist. Your comments on VIX also don't make a lot of sense. You're saying that when an event happens that will inevitably lead to volatility on VIX suddenly going higher, the bid/ask spread becomes so wide that an offer won't be hit for less than intrinsic. Let's examine that statement. When the volatility on VIX suddenly goes up, by it's very definition extrinsic value also goes up. So the situation you cite, a sudden increase in VIX volatility, is the very situation when it is least likely that the bid/ask spread would be so high that a resting offer for intrinsic wouldn't be hit. Extrinsic on VIX is always large, it's huge with unexpected moves. It's just completely implausible that the actual market would be outside that. Now for the answer to the bonus question, the difference between VIX and a stock is that you can't trade the underlying. So, while you could construct a synthetic option on a stock and capture the volatility upside at no cost, you technically can't on VIX. That said, there's a vanishingly small chance of the situation you cite happening in real life. I think you probably just supposed it, and maybe you actually saw it in published bid/ask, but of course that doesn't reflect what you could actually get if you put in an offer inside the spread. Again, cash money to you if you can show me your offer for intrinsic sitting unfilled on VIX.
Yes, I am aware of the differences between European and American options... These differences, as suggested by a few others, would arise in some particular circumstances, which are mostly esoteric and boring to discuss. Furthermore, yes, bid/ask can play into this. However, in an overwhelming variety of cases exercising early is much more suboptimal than paying any sort of bid/ask, even in a distressed mkt. Obviously, if you don't like the bid/ask on the options, you can, in most cases, trade the underlying delta. At any rate, there's really nothing to discuss, as it's all relatively simple.
On wide bid ask spreads in VIX options... the only reason for a wider spread to exist is when the underlying (the VIX futures) is moving a lot on a second to second basis and with not much liquidity (size in the book). Possible gaps tomorrow doesn't really have anything to do with the bid ask spread now. And @Sig is correct when he says that any offers under intrinsic will get filled pretty quickly, depending on what theoretical flesh there is on the bone. The bone being the intrinsic value, flesh the extrinsic premium. But, back to the topic... I think OP was pointing to buying long term SP500 options to get long for a VIX spike. Not VIX options... And that's not a great idea, since long term SP500 options don't move much in IV compared to front month.