Volatility Trading Outlook With The S&P 500 At All Time Highs

With the debt ceiling drama behind us the S&P has responded by making new all-time highs, while the VIX has fallen back to levels from Sept 20 and are VIX futures are back in a moderate contango. From the VIX Futures Data page:

Since Oct 18, VIX and VIX futures have been essentially frozen with intraday ranges of only a couple points for VIX and a range of closing values of just 0.38 points. The fact that VIX futures across all months are not declining, but flat (and ever so slightly up in months 3-7), is indication that all may not be well -- especially as the S&P is hitting all time highs. Usually when we see the VIX term structure hold steady like this investors are starting to pick up on some sort of risk on the horizon (see May 10th - 21st), however, no risk seems to be readily apparent at the moment (although I can name several that are on my mind). Maybe this is just a period of consolidation after a swift move down, but it doesn't quite sit right with me.

It is a five week roll period this month, with 17 trading days still left until November futures expire on Nov 20. Assuming we manage to avoid unforeseen drama during this time we should expect Nov futures to converge towards VIX (Nov currently at a 11% premium to VIX), and VIX to fall along with HV20 towards HV60. This will cause VXX to drift lower and SVXY higher, however the entire futures curve is once again rather compressed with limited room to the downside and larger risk to the upside. I see a ceiling for XIV over the next few weeks in the $32-33 area (~$125 for SVXY). For ZIV, $36 looks to be the limit.

With people increasingly predicting new highs and getting greedy I start to get concerned and like to raise cash. No one really knows if we'll go on like this for months or if the rally ends tomorrow, but all good things come to end so it's always good to take profits along the way and raise stops to help manage risk.

. . . . . . . . . . . . . .

Stay up to date by having posts sent directly to your RSS feed or Email.

Is VIX Expensive Yet?

Today the VIX closed at 16.6 while actual market volatility over the past month (HV20) closed at 8.71, resulting of a volatility risk premium of 90.6% (calculated as (VIX/HV20) -1 ) -- (See VIX Futures Data page).

Traders will often look at what is know as the "volatility risk premium" to determine if VIX is cheap or expensive. The volatility risk premium is essentially a comparison of the VIX (expected volatility over the next 30 days (annualized)) and HV20 (actual market volatility over the past 20 trading days, i.e. the trailing 30 days).

The logic is that the market going forward should typically experience a similar amount of volatility that the market has experienced in the past. However, we typically see a VIX greater than HV20 since sellers of options need to be paid a premium for a certain amount of risk that traders expect in the market. A greater amount of expected volatility will cause the premium to increase.

A simple interpretation of this measure is that VIX is considered "expensive" when it is much greater than HV20, and "cheap" when it is much less than HV20.

While this is a relative measurement, today's volatility risk premium of 90.6% looks pretty expensive. But don't expect to VIX to fall just yet.

First of all, the value is a ratio. As actual market volatility increases (during a large rally or large sell off) the ratio will get smaller (given a steady VIX).

Also, 90.6% isn't too crazy just yet. Below are some points over the past 10 years where the market saw other peaks in the volatility risk premium.
  • 2/15/12    151.5%     (VIX 21.14; HV20 8.40)
  • 3/5/12:     153.6%     (VIX 18.05; HV20 7.12) 
  • 5/18/12:   113.1%     (VIX 25.10; HV20 11.78)
  • 9/5/12:     195.2%     (VIX 17.74; HV20 6.01)
  • 12/28/12: 128.8%     (VIX 22.72; HV20 9.93)
  • 1/31/13:   157.8%     (VIX 14.28; HV20 5.54)
  • 4/1/13:       74.6%     (VIX 13.58; HV20 7.78)
  • 6/3/13:       62.9%     (VIX 16.28; HV20 9.99)
  • 8/9/13:     103.5%     (VIX 13.41 HV20 6.59)

The highest this ratio got before the Aug 2011 selloff was 64.1%, which occurred on 8/1/11 (VIX 23.66; HV20 14.42). After that HV20 then pretty quickly rose to a lofty 50.66 (8/29/11) and the ratio hit -36.3%.

More fun facts: 
  • The highest HV20 over the past 10 years was 85.19 (on 11/5/2008).
  • The highest VIX to HV20 ratio over the past 10 years was 289% on 12/31/10 (VIX 17.75; HV20 4.57)

Lastly, don't forget that if you trade VIX ETPs, they all track to VIX futures and what matters most is the term structure.

Happy Trading!

. . . . . . . . . . . . . .

Stay up to date by having posts sent directly to your RSS feed or Email.