Updated: Apr 12, 2019
I had several questions yesterday about why we are not back into all our "bullish" trades like MDY stocks, SVXY, VXX puts etc. The commonality I was hearing was that since the front two month VIX futures are back in contango now, that must mean we're all clear to go for it right?
While it's true the VIX futures are in contango again, albeit only moderately at around 3.5%, remember there are many other indicators that I track to gauge the pulse of market participants. And in fact I would go a step further and say that the VIX futures aren't even in my top 5 as far as "go-to" indicators. VIX futures are just a small part of a much larger puzzle.
One indicator that I particularly like, and one I've highlighted several times before is the relationship between all the various VIX style indexes of different time frames.
VIX9D - 9-day forward implied volatility VIX - 30-day forward implied volatility VIX3M - 3-month forward implied volatility VIX6M - 6-month forward implied volatility VIX1Y - 1-year forward implied volatility
All of these products are measuring the same thing, just over different time frames. They are the markets expectation of future price movements in the S&P 500, based on S&P 500 options activity.
The higher the value, the more market participants expect the S&P 500 to move. And that's in either direction remember, up or down. The VIX, and all the various VIX style indexes only measure expected magnitude, not direction. So while it's typically the case that when markets go up volatility goes down, that isn't necessarily true and there are times when they both move in the same direction. So it's best to view the VIX style indexes as directionless.
Just for some context, let's plot this relationship from a few days before this recent S&P 500 correction began. A few months ago on September 21st, 2018 I would consider that to be a "normal" market.
Sept 21, 2018:
There's a few things to notice here:
1) The shape: Notice how the shortest term product VIX9D is the lowest value, followed by the 30-day VIX index, and then followed out further in time to the right with the 3-month VIX3M, the 6-month VIX6M, and the 1-year VIX1Y. This upward sloping "cash VIX term structure" where the further we look out in time the higher the values are represent normal uncertainty.
2) The magnitude: See how the gap between the far left VIX9D and the far right VIX1Y is substantial? On that day the VIX9D was 10.63 and the VIX1Y was all the way up at 17. Under normal conditions we should expect more potential movement the further out in time we look, so a larger gap between VIX9D and VIX1Y is considered normal.
Now let's take a look at a plot from last Friday, just before the much anticipated G-20 meeting over the weekend:
Nov 30, 2018:
So clearly this isn't normal. First, the shape isn't normal in that it's not a continuous upward sloping relationship. Secondly, the magnitude isn't normal either because the gap between values is very tight, to the point where market participants are expecting as much movement over the next 9 days (VIX9D) as they are the next 1 year (VIX1Y).
Fast forward to today, the g-20 meeting came and went with very little substance, but the headlines were that a truce was struck in the ongoing US China "tariff war" if we can call it that.
So predictably, a lot of people rushed in to fresh new positions thinking it was going to light a fire under the market and launch a nice rally into year end. So what does the curve look like now, after all the dust has settled? Is it back to normal?
Nov 30, 2018 (blue) vs Dec 4, 2018 (orange)
Not really... The overall curve has dropped slightly, the VIX is a little over 1 handle lower, but much of the uncertainty has remained. Shape and magnitude are both still not reflecting a market that fully believes in the truce over the weekend. Typically the VIX9D is the one that moves the fastest, followed by the VIX, and if there really was full conviction we were out danger here we would have seen the VIX9D quickly retreat below the VIX, and the entire front end of the curve to shift much lower.
So I'm not saying that won't happen, we'll be watching closely the next few days. Maybe this "vol crush" is just slow getting started. The fact that the S&P 500 is down -0.7% this morning, yet the VIX is flat, that's a good sign. It means it'll take more than just small drops to rattle this market. However we don't front run so we'll wait for confirmation of the signal before acting.
The point today is, we need to look at a multitude of volatility metrics to base trade decisions on, not just the very narrow view of front month VIX futures contango.
Keep an eye on this VIX9D : VIX : VIX3M : VIX6M : VIX1Y relationship.
Add it to your arsenal of market indicators and I think you'll be better prepared to gauge what direction market participants truly believe we are heading going forward. Right now, it's telling me we're still in yellow light caution range.
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