Historical Context Of The VIX And VIX Futures Super-Cycle

VIX perked up in July as it rose 65% from a low of 10.32 up to over 17 in early August. This translated to gains of almost 30% in VXX, which tracks the daily movement of first and second month VIX futures.

Looking at our chart showing the past six months of VIX and VIX futures movement (from the VIX Futures Data page) there is a pronounced rise in all VIX futures over the month of July, bringing levels back up to those last seen in March.

Market participants have become accustomed to these VIX spikes and stick to a playbook of shorting volatility as it approaches 20. Recently this strategy has worked well but will it always work?

To help answer that question I've created an Archives page dedicated to historical data of VIX futures, containing a visual representation of VIX futures data over the past eight years to document the most recent VIX super-cycle.

On this page you can see how VIX futures traded from the calm market of 2006 through the chaos of 2008, all the way back to the calm of 2014. To give this data some context I've also added a selection of the more significant news events that have impacted the market. This allows you to see when various events happened and how they impacted the market. Some examples covered are:

• inversion of the bond yield curve in 2006,
• Bear Stearns downgrade & liquidity rumors,
• signing of the $700B financial bailout bill (Emergency Economic Stabilization Act of 2008),
• points when QE1, QE2, and QE3 begin and end,
• events leading up to the Flash Crash,
• Greek voters reject ruling parties in elections to put bailout at risk and possibly leave the Euro.

Some of the more enlightening graphs are:

Feb 2007 - Aug 2007 when mortgage defaults were rising as adjustable rate mortgage payments reset. The effect was a 50% rise in front month VIX futures over four months while in a contango term structure.

... Feb 2010 - Aug 2010 as Greece requested a bailout and fear of contagion spread across Europe.

... and Aug 2012 - Feb 2013 which shows the magic moment when the FOMC unveiled its open-ended QE3 program to place the most recent lid over volatility. 

You can view all of the graphs on the Archives page. If you are a Trading Volatility+ subscriber you get the extra benefit of using interactive graphs for your research. If you are interested in becoming a subscriber you can do so at the Subscribe page.

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.

Trading VIX Around the Upcoming Debt Ceiling Debate

With another debt ceiling debate looming just around the corner, many volatility traders ask "How do I play this event?"

Well to answer that question I like to first figure out where VIX is trading. Currently:

• VIX sits at 14.42 (currently +9.9% on the day)
• Actual volatility of the S&P 500 over the past  month (HV20) is at 11.50, 
• Actual volatility over the past 3 months (HV60) is 9.58. 

These values tell us that a VIX of 14.42 is actually high given the amount of volatility that the market is actually experiencing -- VIX is at a 25% premium to HV20 and a 50% premium to HV60. The market is already expecting a greater amount of volatility in the next month compared to what we have experienced in the past 3 months.

The recent rise in VIX to 17 in late August was for the most part attributed to the events in Syria. Once was a diplomatic solution was "found" VIX began to retreat to normal levels. As you can see by the green circles in the graph below, VIX tends to fall toward the "floor" set by HV60. With HV60 currently below 10 and VIX at 14.39 there is still a long ways to fall (33%). However, just because the floor is down below 10 doesn't mean that it'll necessarily make it down there.  HV20 is on the rise, moving from 6.49 in early August to above 11 today, an indication that the market as a whole is growing more volatile.

An interesting point in the chart above is 8/30/13 (see red rectangle) when the value of front month VIX futures (M1) was 17.5 and HV20 was 9.58, an 83% premium. It is rare for front month VIX to be above 17 while HV20 is below 10. In fact, in the past nine years this has only happened a handful of times (7/2004, 12/2009, 3/2010, 11-12/2010, 1/2011, 4/2011, 2/2012, 8/2012, 12/2012). In most instances M1 and HV20 converge towards each other over the next 3-6 weeks then rise rapidly together as VIX and actual volatility spike. We'll soon find out if the 8/30/2013 instance follows a similar pattern.

But given that VIX is trading at a premium to actual volatility and VIX futures are in contango, the expectation is that VIX and VIX futures will continue to fall. That means the "correct" long-term play as of now, due to the structure of VIX ETPs, is to continue to short volatility both for near-term VIX futures (long SVXY/XIV or short VXX/TVIX/UVXY) and medium-term VIX futures (ZIV), although I believe that smaller positions are warranted given the compression in the VIX futures curve.

Now that we've taken a look at the technical side, let's get back to the question about the debt ceiling.

We've been through several rounds of debt ceiling political theater weighing on the stock market. After a few rounds of debt ceiling and sequester deadlines in the past 2 years the market seems to be getting used to the sequence of events, complete with a last minute deal to once again kick the can into the future.

One idea of how to play the Sept/Oct 2013 episode is to wait for a VIX spike that occurs in the final hours of negotiation just before the deadline and short volatility. History gives us some positive data that this could be a good play. However, this strategy depends on several points:

1) Will market participants fret enough to cause a rise in VIX in advance of the event?

• In the July 2011 episode VIX ranged between 15 and 21. In Nov/Dec 2012 VIX ranged between 15 and 19.6. After hitting 12.52 last Friday, VIX is now at 14.32 with just one week left for congress to pass a "Continued Resolution" to continue spending after Sept 30th, and several weeks until all extraordinary measures to continue spending have been exhausted by the Treasury. Not only is the market not worried about this, but there's not even the infamous "countdown clocks" on the major media stations. I think you have to assume it will be political grandstanding business as usual and implied volatility will rise over the next several weeks, but it is not clear if this will happen as a gradual build up to the event, or more quickly just as the event is about to occur. Being long VXX over the next few weeks could be difficult given the "headwind" it faces due to the contango term structure. 

2) Will a deal get done?

• I think the answer is yes and I believe the market believes the answer is yes. Whenever this happens, the immediate reaction will most likely be positive and make for a very good short volatility play (assuming there is a build up in VIX leading up to it). 

3) Will a market-positive deal get done?

• Given the ratings downgrade and sell off after the July 2011 episode, this question should be of concern to investors as well. While a deal is likely to get done, investors will be looking at the "cost" of the deal. The details of  the deal, as well as the manner in which it is achieved, are just as important as the deal getting done in the first place. This will remain an unknown until it happens but is something to keep an eye on after the immediate reaction.

 
I prefer to take the information one day at a time to see how this episode plays out, closely watching for any significant changes to the VIX futures term structure and ensuring I have appropriate stops in place. The biases remain positive for SVXY, XIV and ZIV and negative for VXX, TVIX, and UVXY so I like to use those to my advantage while they exist.

Also remember that some periods of trading are easier than others. A directional move is easier to trade and more profitable than a choppy market, and you have to expect that the market over the coming weeks will be choppy and event-driven. There is a good case to be made to avoid this period altogether and wait for the "easy" money to be made once a new direction has been established.