Disclaimer: The information found on this site is meant for educational and informational purposes only. Nothing on this site should be construed as a recommendation or solicitation to buy or sell derivatives or securities or to trade any particular strategy. Trading of derivatives or securities has large potential risk and you must be aware of and accept all the risks. Past performance of any trading system or methodology is not necessarily indicative of future results. No representation is being made that any account will or is likely to achieve performance results similar to those discussed on this website. Hypothetical or simulated performance results have certain limitations and do not represent actual trading.

Sunday, September 30, 2012

Differences in Perception & Reality: Time to Go Long Volatility

Back in late August and early September, and ahead of ECB announcement, S&P500 Index experienced a period consolidation.  As you can see in the first blue oval, the market went sideways, then took off after  Draghi's announcement of Outright Monetary Transactions (OTM) policy.  Over the past two weeks, the market has also undergone a consolidation of sort.

The interesting difference between these two periods of consolidation is VIX (shown in plum) movements and my Fair Volatility Estimate or FVE Indicator (shown in blue).  As you can see indicated by the red arrow, VIX steadily rose ahead of the ECB announcement to 18 level, while FVE remained low and in a declining trend.  After the ECB announcement, VIX plunged.

Recently, however, FVE has been steadily rising, yet VIX has remained mostly below FVE Indicator's values during this consolidation and also below its values during the previous consolidation.

The reality is that the current ongoing consolidation of the S&P500 Index is showing greater volatility, yet market volatility perception as measured by VIX is not quite reflecting this.  I believe presents a good expected payoff scenario in favor of going long volatility.

Thursday, September 6, 2012

VIX Back Month Futures At Record Premiums!

VIX back month future prices seem really high to me.  March 2013 VIX futures are trading at 27.30, April 2013 VIX futures are 27.85, and May 2013 VIX futures are 28.20!  Historically, the median VIX level has been 19.8.  Furthermore, I calculated that VIX has been above 40 just 3.6% of the times since 1994, but 29% of the times it has been below 16.  With these probabilities, I get 8 to 1 advantage for me to sell back month VIX futures.  I thought this has to be an anomaly!

So I plotted a graph showing the premiums of the first seven, VIX monthly futures prices over spot VIX.  As you can see in Yellow, the rolling seventh month VIX futures prices have indeed been trading at record premiums over spot VIX.  On August 17, when spot VIX hit a five-year low of 13.45, the VIX March futures prices were trading at 93.7% premium.  Since then, VIX has climbed to 17.74, reducing the premium March 2013 VIX futures trade over spot VIX to 53.9%.  However, this premium is still very high based on historical premiums

Something does not make sense, unless...

VIX futures term-structure and the gaping spread between the seventh month VIX futures prices and the second month VIX futures prices are warning us of an impending correction.  In looking at the graph below, the peaks in the spread between VIX seventh month future price vs the VIX second month futures price has preceded 1 to 2 weeks prior to the peaks of SPY prices.  The graph below looks pretty convincing, especially when looking at how closely SPY prices have moved with the rise and fall of the price spread of VIX futures.  Is the recent peak on August 17, 2012 signaling an equity market top with prices expected to start falling any day now?!

I am not so convinced of what VIX futures term-structure is signaling...

The graph below shows that prior to SPY price corrections, the ratio of VIX to a measure of realized volatility has in recent years always been on the low side.  The blue lines in the chart below show corresponding values of the ratio of VIX over Realized Volatility right before SPY prices began falling and subsequently underwent either a minor or major correction.  Currently, however, this ratio remains at very high levels.  In other words, realized volatility has been very low recently.  More importantly, realized volatility has yet to show a rising trend.  Until I see realized volatility start to jump in SPY prices, I would remain bullish on the equity markets.


I can understand that with SPY prices at new recent highs and with tremendous expectation built in to the equity market for imminent announcement of credible European government and central bank policies, investors would want to hedge their portfolios with VIX futures.  However, the discrepancies between implied volatility and realized volatility to that of VIX futures prices seem way out of line.  Something has to give.  Perhaps buying the 2nd month VIX futures and selling the seventh month VIX futures could be a good bet if the spread between the two is expected to decrease.