From Volatility Futures & Options:
How To Manipulate VIX Settlement Price
VIX expiration day often coincides with particularly heavy trading activity in underlying SPX options. VIX settlement value, or VRO rarely matches either the Tuesday close or Wednesday open prices on the "cash" index, prompting pundits to blame VIX settlment for being manipulated. A popular theory is that VIX settlement value is being pushed up or down with huge SPX trades, referred to as "carpet-bombing". Some say that the manipulative trades are concentrated around high-vega strikes, others concerned specifically about puts. In this post I explain why large trades are not likely an explanation for VIX manipulation, and instead how VIX settlement value can be artificially increased for less than one hundred dollars, how VSTOXX futures and options are not subject to such manipulation, and propose a simple modification that makes VIX manipulation too expensive to be profitable.
VIX settlement value is determined by a Special Opening Quotation, based on the opening trades of SPX options instead of quotes. It is true that VIX settlement value can be made higher or lower by placing a big order that would result in a trade. The quantity necessary to move ATM SPX options is significant, and such trade would have to either be maintained and hedged until expiration, or exited immediately possibly with a large slippage. For this reason I don't think that it would make sense for a trader to attempt to manipulate VIX this way - it is very costly, and possibly very risky if the market moves against the trader, and I believe that heavy trading on the open of VIX expiration does not signify VIX manipulation, but rather legitimate SPX trading activity.
However a different form of VIX manipulation is possible. The VIX calculation formula is a weighted sum of option prices, with weight proportional to 1/K^2, where K is the strike. When K is getting smaller, 1/K^2 is getting bigger. While in theory such growth in a weighting term is mitigated with declining put prices (as K is getting smaller puts get cheaper) in practice it seems possible to "blow up" the VIX by placing orders - nickel bids that are most certainly would get executed - at very low strikes. It is a rather small investment - a few cheap options with limited risk since all options are bought - no short positions.
How this would work in practice:
1. On Tuesday before VIX expiration before the close, a trader purchases a significant amount of VIX calls, ATM or slightly OTM, that have the most potential gain from an unanticipated VIX increase.
2. On Wednesday before the open, a trader places 0.05 1-lot bids on low strikes SPX puts for the next month's expiration (the expiration that determines VIX settlement) ...MORE