The VIX Futures Curve and Stock Market Sentiment

Is the VIX Futures Curve a Concern for the Markets?

Despite the 'Fear Index' Falling the Stock Market Sentiment Is Far From Complacent!

by Ian Harvey

August 20, 2012


Phrases like "sleepy," "range-bound," and even "boring" continued to be tossed around last week, even while U.S. stocks quietly trekked to a sixth weekly win, putting new annual highs within reach. Helping spur the (modest) buying activity was encouraging economic reports at home and renewed hopes for further stimulus in China.

Against this backdrop, the CBOE Market Volatility Index -- the so-called "fear" barometer -- lost nearly 8.9% on the week and notched a new annual low of $13.30. This move, along with the current state of the VIX futures curve, sparked a lot of chatter in the financial media, but many VIX watchers may be overreacting.

The Importance of the VIX Below 14

"…..Sleepy summer markets could be getting ready to give way to something more violent this fall...The VIX futures curve is at the steepest level since before the financial crisis began, with each progressing month at a higher and higher level with longer term volatility at a much higher premium than short-term volatility ... The VIX, itself, is the market's fear meter and it is also trading at a pre-financial crisis level, hitting a low of 13.71 last week ... 'It's basically telling you over the next six months, the market could have some form of volatility spike,' said Deming. He said investors appear to be hedging against a whole stream of major events, starting with the Jackson Hole speech by Fed Chairman Ben Bernanke on Aug. 31, the Fed meeting in September, Europe's handling of its debt crisis, and the November elections. There is also the pending "fiscal cliff" when the Bush-era tax cuts expire Dec. 31 and automatic spending cuts take hold Jan. 1 if Congress does not act..."
-CNBC, August 17, 2012

"…..As markets' summer doldrums leave financial volatility and trading volumes at their lowest in years, investors are puzzling over what appears to be complacency about the potential for renewed market tensions during an event-packed September ... But if markets are supposed to discount future risks, many say potential ructions in September -- evident from even a glimpse at next month's event diary - should imply more caution than we are now seeing. And if this is just a market anomaly, then investors should be exploiting it by buying what looks like relatively cheap insurance for the bumpy road ahead. As we move into September and possible headline risk on both sides of the Atlantic, it is worth remembering that since 2010 the VIX has only dipped below 15 twice. In both instances the subsequent two-month performance for the S&P 500 was negative….."
- Reuters, August 17, 2012

This past week, has seen a lot of discussion about volatility -- specifically, the The CBOE Market Volatility Index (VIX – 13.45) and the current structure of the VIX futures curve -- on Twitter and financial web sites.

The excerpts above capture a major focus of traders in recent days -- we are headed into an event-packed September amid a low absolute level of the VIX and a steep VIX futures curve. The takeaway from a majority of market participants is that a low VIX level is a sign of complacency that leaves the market vulnerable. And the conclusion from the steep VIX futures curve is that there will be a VIX spike in the coming months.

Volatility spikes are normally preceded by low levels of volatility, therefore many are advising caution about a potential volatility spike on the horizon.





HLF July 47.50 Calls 53% APPL Aug 650 Calls 67%
DLTR Aug 110 Calls 32% UIS Oct 17 Calls 79%
HSY Aug 70 Calls 56% TSO Nov 25 Calls 54%
NKE Oct 92.50 Calls 49% HLF July 47.50 Calls (again) 38%
FB Aug 25.00 Puts 500% DISH Sept 30.00 Calls 100%
APPL Jan 13 650.00 Calls 71% CSTR Oct 42.50 Puts 400%
LNKD Aug 92.50 Puts 30% LNKD Aug 100.00 Calls 250%

Is Complacency A Reality?

Is there really a backdrop of complacency, as is evident by the VIX or otherwise? For example, from the excerpts above:-

• “…..He said investors appear to be hedging against a whole stream of major events…..”

• “…..then investors should be exploiting it by buying what looks like relatively cheap insurance for the bumpy road ahead……”

Does this represent complacency, or does it represent a mode of caution and/or fear? To the degree that it is caution -- the "bumpy road ahead" may be priced into the markets. Throw in the following facts that suggest there is anything but complacency:

1. Retail investors withdrawing cash from equity mutual funds

2. Short interest hitting a year-to-date peak and reaching the level of September 2011, which preceded a major rally

3. VIX call open interest notching a new all-time high (more on this below)

Also, keep in mind that as professional traders give you warnings about the low VIX level, a bull could easily counteract a bear with the following facts:

1. Current historical volatility is 12.84, below the VIX reading

2. Low VIX readings can persist for months, if not even multiple years (1993-1996, 2004-2007)

3. While 15 can be viewed as "extreme" dating back to 2008, the extreme dating back to the early '90s is 10 (or even lower). And a VIX rally from 10 in the '90s was often coincident with a rallying stock market.

The VIX Futures Curve

Looking at the steepness of the VIX futures curve -- whereby longer-dated VIX futures are significantly higher than the cash VIX. It can be noted that when the steepening occurs, we get warnings about a selloff ahead. But, in checking our historical VIX futures data (which goes back to 2004), it is evident that a steep curve is not a sell signal.

In fact, when the four-month VIX futures contract was 40% higher than the cash VIX (which is considered steep), the Standard & Poor's 500 Index (SPX - 1,418.16) was higher three weeks later 80% of the time. Moreover, it was higher 71% of the time three months after such a signal. These numbers are actually better than the at-any-time percentages in the table below, even though many view the steepening curve as a bearish signal!

Finally, in 2008, the four-month VIX futures contract was just 30% and 20% higher ahead of two major sell-offs, implying expectations for a sell-off were not as high relative to now.

Is a Steep VIX Futures Curve Bearish for the Market?

Perhaps the VIX term structure in April 2012 is fresh on the minds of market professionals, as it was similarly steep at that time and preceded a correction. One difference between now and April is that short interest in April 2012 was very low, implying there was a little bit of complacency after a short-covering rally. Moreover, volatility option players were more divided on their outlook for volatility, whereas now it is nearly unanimous that volatility is headed higher.

For example -- continuing on the subject of volatility expectations -- check out the difference between call and put open interest on VIX options at present versus April 2012 on the chart below. Specifically, a low relative level of put open interest at present is accompanying record high call open interest on VIX options, whereas in April, put open interest was relatively high as well.

The point is, in April, expectations for a volatility spike were not necessarily a sure win, ultimately leaving the market vulnerable as European tensions flared and U.S. growth slowed. Now it appears the consensus is playing an imminent spike in volatility, which may reduce the odds of a spike actually occurring, as market player’s hedge for negative outcomes ahead of the events of September and the elections.

Call & Put Open Interest VIX Options 2012

Red = Put Open Interest

Green = Call Open Interest

Conclusion of VIX Futures Curve

The bottom line is if the market pulls back, it is for reasons that have little to do with the level of the VIX or the term structure of VIX futures. Therefore, view these concerns as just another in a long list of worries (Europe, ”fiscal cliff”, and elections) that have kept investors on the sidelines and short interest elevated, which has bullish contrarian implications in a market with strong price action.

Therefore, use any pullbacks as buying opportunities. One sector to consider is homebuilding.

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