Term Structure of the VIX
I wanted to point out an observation today. I've been thinking for a bit now that there's a reasonable chance of this market running into some serious bear territory. It appears that that's what the rest of the market is thinking too. This is evident in the term structure of CBOE Volatility Index(VIX_) options and futures.
VIX options are a little tricky. They settle into cash and the underlying is the value of VIX at expiration. Incidentally the futures have that same underlying. Therefore, a trader of VIX options shouldn't look to the published VIX index as the underlying. He or she should consider the future to be the proxy for the underlying.
That being said, the current implied future for August VIX options is around 19.75, just about 0.35 above the spot VIX. However, as the time to expiration gets greater, the implied VIX future has greater value. For example, the September implied future is 21, the October is 21.75 and the November is 22.125.
What's it mean? Given that the VIX is often referred to as the fear index, the options market is telling us that investors are increasingly nervous. They, like I, think there could be some short-term rallies, but there are economic woes that are weighing on this market and it may be only a matter of time before we see some real volatility (of the bearish variety).
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So we get a four-day rally in the markets, and wouldn’t you know it, yet another implosion in the iPath S&P 500 VIX Term Futures (NYSE: VXX). The SPDR S&P 500 (NYSE: SPY) lifted about 2.5% while VXX has pared about 12%. Volatility as an asset class works … pretty poorly.
But hey, its actually not a horrible setup for VXX, at least from a CBOE Volatility Index (CBOE: VIX) tracker standpoint. VIX closed at 18.86 yesterday. July VIX futures closed at a $1 premium, not terribly high. And the August futures closed .85 over July. That’s all pretty flat in VIX Term Structure land. And that’s a relatively good thing for VXX, which as you might remember, has to roll from the first cycle out to the second cycle to maintain a constant 30-day duration. Yes, VXX loses small each day, but that premium often exceeds $2.00, so by contango standards, its not terrible. What’s more, VIX itself is kind of middle ground in the high teens.
There is one big fly in the ointment though. If the market hangs in a couple more days, VIX is going to get very heavy, very quickly. The July cycle is the worst cycle of the year for VIX. At least that’s what I found running numbers for my book. Summer dries up volume to begin with, and having a long holiday weekend smack dab in the middle of the expiration cycle mutes any desire to pay up for options. Obviously an *event* trumps any of this, but the pressure really reside with the option buyers.
So what I’m saying is that the relatively flat and docile VIX term structure can get steep before you know it. And that will happen via a drop in VIX itself, followed by weakness in July futures.
I’m small long the VelocityShares Daily Inverse VIX Short-Term (NYSE: XIV), and would buy more into any VXX strength over the next couple days, so that’s my (very short-term) opinion.
Follow Adam Warner on Twitter @agwarner.
