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1M-3M Volatility Term Structure Plunges To Steepest In Years (VIX/VXV)

Tyler Durden's picture




 

The ratio between VIX (implied vol as determined by 1 month out SPX options) and VXV (3 month Implied Vol) has just dropped to the lowest it has been since the end of 2006. After hitting a post-Lehman high of just under 1.3, VIX/VXV has plunged to 0.7917, a steep drop of 0.07 in just one day, as near-term equity vol is being aggressively sold, even as forward implied vol remains resistant to day to day changes in the market. Whether or not this is predicated by the QE2 event occurring somewhere inbetween the 2 term points is unknown, and irrelevant, but traders certainly seem to be far more comfortable with 1 month volatility and are selling much more of it than its longer-dated cousin. However, as Chris Cole pointed out earlier, this could be a very dangerous underestimation of the possibility for an exponential jump in near-term vol, in a time when correlations are near all time highs.

Here is the chart of VIX/VXV:

And here is the full volatility surface over the past 3 months courtesy of Arthemis:

And once again, here is Cole's explanation of why investors should be careful when trying to trade the term vol curve.

The subtlety of the relationship between volatility and correlation should not be underestimated. To give an example, in the third quarter I heard many pundits claim that long-dated volatility was significantly overvalued. This was largely due to the observation that the back-months of the VIX term structure rose above 30 even as the VIX dropped to the lows 20s. I heard one "expert" on CNBC make the point (erroneously) that five month VIX futures at 30 were implying the S&P 500 index would move +/-2% on average per day through the end of the year. This simplistic interpretation ignores the concept that when you sell volatility you are, in essence, selling insurance against an unknowable adverse event (a market crash). The premium of the insurance contract must be probabilistically adjusted by the shifting likelihood of that event occurring. The trader who is short volatility must build a premium into their expectation of future volatility to account for the fact vol rises faster than it drops. As component correlations rise the probability of violent exponential jumps in index volatility are greater! Hence the premium over today's volatility level (current VIX) should be much higher to appropriately account for the added risk. The analyst who advises shorting long-term VIX futures simply because they are above 30, while ignoring correlation a risk source, is missing a big part of the picture. At high correlation levels shorting volatility becomes much more dangerous. Consider the chart below which tracks the relationship between the slope of the intermediate-term VIX futures surface (months 4 and 7 measured by proprietary index) and implied correlations. As indicated, the slope of the VIX term structure (on an absolute value basis) can be thought of as a risk premium measuring expectations of future volatility of volatility. The risk premium increases when implied correlations stay elevated over extended periods of time.

So more troubling than demonstrating a complacency toward short-term risk, the vol curve could merely be demonstrating the current vol trading generation's inability to trade properly in an environment in which correlations are now at new, much higher, regime levels.

h/t Credit Trader

 

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Mon, 10/11/2010 - 15:59 | 641510 gwar5
gwar5's picture

I'm closing my eyes so nothing bad can happen

Mon, 10/11/2010 - 16:02 | 641526 What_Me_Worry
What_Me_Worry's picture

or you could just watch CNBC

Mon, 10/11/2010 - 16:05 | 641535 SheepDog-One
SheepDog-One's picture

LMAO at the blatant last minute Skynet 11,000 stick save. WTF, give up its all futile. Black Swans blotting out the sun doesnt make a bit of difference. 

Mon, 10/11/2010 - 16:14 | 641560 Steak
Steak's picture

look beyond the stick save and check out the drop that preceeded it.  if you check intradays of today (starting 3:15) and 10/7 (starting 12:15)  you'll notice a roll over and sink down pattern very reminescent of the flash crash.  they all roll over with barely an uptick, which to me says the bid has been limited or pulled entirely.  imo it is offensively designed algos engineering a pulling of the bid so that the subsequent strong bounce can be profited from.

Mon, 10/11/2010 - 18:05 | 641878 Greater Fool
Greater Fool's picture

Yes, it has looked to me for quite a while, even before the flash crash, that some people have working strategies that induce overshoot. To the degree that algos key off other bids, you should be able to do it: Pull your bids and drop a big market sell, generating a cascade downward. It only works if asks fill the gap in the book faster than market buys arrive, though.

Mon, 10/11/2010 - 18:12 | 641895 jm
jm's picture

Look at RTN.

Mon, 10/11/2010 - 16:22 | 641582 tmosley
tmosley's picture

Then the computers shall trade in the shade.

Mon, 10/11/2010 - 16:06 | 641537 wiskeyrunner
wiskeyrunner's picture

Buy the close sell the open....Stock futures rally 90% of the time. Just by the close and sell at 2:00am cst. 

Mon, 10/11/2010 - 16:07 | 641542 traderjoe
traderjoe's picture

Only the latest example of how BB's massive liquidity is masking the price-discovery mechanism of the markets. As returns get lowered, traders may be selling vol to gain some 'income'. 

None of this will end well, and BB does not care. The plan is in motion...

Mon, 10/11/2010 - 16:08 | 641546 wiskeyrunner
wiskeyrunner's picture

Last 15 minutes saw all the action today, 40 point Dow drop followed by a 40 point Dow rise. Stocks will not fall going into the election can't anyone get that through there head.

Mon, 10/11/2010 - 16:25 | 641593 doolittlegeorge
doolittlegeorge's picture

stinks to high heaven, don't it. QE 2 well underway?  As Machiavelli said "look to the result."  The market doesn't go down, does it?  Up next?  Massive bailouts of state and local governments.  And I mean MASSIVE.  If you haven't been all in in municpal debt this year "you may have missed out on the biggest rally in history."

Mon, 10/11/2010 - 17:30 | 641791 wswarrior
wswarrior's picture

You're right, stocks can't go down ahead of an election.  Why don't you check out the chart from October 2008?  Please explain that one to me.   

Mon, 10/11/2010 - 16:12 | 641555 Ned Zeppelin
Ned Zeppelin's picture

If you are short, you are crazy. 

Mon, 10/11/2010 - 17:11 | 641729 rd
rd's picture

I believe that's the sort of prevailing mentallity just before a crash...

Mon, 10/11/2010 - 18:25 | 641923 Sam Clemons
Sam Clemons's picture

If someone who is short is crazy, then I am insane and in some pain right now.  But its all good.  Nothing changes in history - not even with QE5000.

Mon, 10/11/2010 - 20:56 | 642173 Implicit simplicit
Implicit simplicit's picture

I hear ya SC. I am keeping my insurance. Good luck.

Mon, 10/11/2010 - 16:15 | 641563 Gloomy
Gloomy's picture

From Marc Faber:

 

 


"Still, what concerns me is the following. At the late August low (S&P 500: 1039) investors’ sentiment was extremely negative. This has since changed radically. The asset inflation trade is back in full swing with investors chasing precious metals, selected high tech stocks (Amazon, Apple, Netflix etc.), and emerging and developed stock markets around the world. Moreover, whereas in June investors were hyper-negative about the Euro (and positive about the US dollar), Dr. Marc Faber Market Commentary October 1, 2010


 

now, investors are extremely negative about the dollar and positive about any other currency.

As can be seen from Figure 14, back in June, only 2% of market participants were positive about the Euro. Now, 96% are bullish! I have explained in the past that whenever the US dollar weakens it is asset price friendly (certainly for stocks and commodities), but that periods of US dollar strength bring about asset market declines (like in 2008). Therefore, as a contrarian I would have to consider the possibility that we are nearing inflection points.

A US dollar rebound and corrections in commodities, precious metals, and stocks!

However, I would use a correction in asset markets as a buying opportunity for equities, as more quantitative easing (money printing) would almost certainly follow (I should add that dollar strength would be favorable for Japanese shares). In the back of my mind, I am naturally concerned that it has become consensus that commodity and stock markets cannot fall significantly (for stocks say 30% or toward the March 2009 lows) because the Fed will print money. It is for this reason that I am currently extremely cautious and that I continue to reduce my equity positions.

A reader asked me if I was still positive about agricultural commodities. Yes, but obviously like precious metals and other commodities they are also vulnerable to a correction. "

 

I would add that VIX under 20 is setting up in my mind for a significant correction in equities and commodities.

Mon, 10/11/2010 - 23:38 | 642431 Minion
Minion's picture

Great post, thanks for putting it up.  This summarizes my view entirely.  We are nearing an inflection point............................... there is waaaaaaaaaay too much belief that QE2 will reboot the bull market.  :)

Mon, 10/11/2010 - 16:28 | 641603 doolittlegeorge
doolittlegeorge's picture

Massive short interest in debt markets=massive plunge in interest rates as "bears have no place to hide." It's a massacreee!

Mon, 10/11/2010 - 17:15 | 641747 hamurobby
hamurobby's picture

Place yer bets!

Mon, 10/11/2010 - 17:32 | 641799 Gen X Gen Y Hybrid
Gen X Gen Y Hybrid's picture

The VIX talk (I apologize) goes way over my head.

I understand volatility, but what does this really mean that it is low right now?

Does it just mean the market is predictable?

What is TD suggesting we trade based on this trend?

Mon, 10/11/2010 - 18:07 | 641884 Greater Fool
Greater Fool's picture

To me, it means the market is pricing in a short-term bounce from QE2 but no real lasting benefit beyond that.

Tue, 10/12/2010 - 01:03 | 642552 Ragnar D
Ragnar D's picture

VIX = volatility index = "fear index", though it doesn't necessarily mean a selloff.  It's an estimate of volatility, up or down, based on options pricing.

In other words, it's a picture of how expensive insurance against up or down moves is.

Mon, 10/11/2010 - 18:16 | 641901 Sam Clemons
Sam Clemons's picture

I think I saw a post on ZH before showing that rapid changes in VIX (up or down) are not good for the market.  I'd like to see that data again if anyone has it.

Mon, 10/11/2010 - 18:30 | 641932 omi
omi's picture

UHM, this is just disengeneous. VIX rolled today. So there really is no jump, but the index started referencing next month.

Mon, 10/11/2010 - 18:59 | 641984 IrrationalMan
IrrationalMan's picture

Agreed Comparing the front month and the third month generic would be more useful as atleast you would have a constant time differential.  To the author's point the vol curve is completely insane right now.  Look at the 10 delta/90 delta options make the skew almost flat until you reach 2 months out and then they shoot up for some nasty skew.

Mon, 10/11/2010 - 20:49 | 642159 Implicit simplicit
Implicit simplicit's picture

 There must be a move towards reversion on the near horizon with the VIX outside the BB along with the dollar. It would seem to be a high probability trade at this point

Mon, 10/11/2010 - 18:31 | 641934 Catullus
Catullus's picture

It's not selling Vix as much as it buying Bernanke Calls on QEII. 

Whoever is selling these Vix Calls is boxing the Fed into a serious corner.

Mon, 10/11/2010 - 18:47 | 641961 tip e. canoe
tip e. canoe's picture

precisely

Mon, 10/11/2010 - 19:15 | 642021 Silverhog
Silverhog's picture

The goal was 11,000 before the election and they have that, a few weeks premature I might say. My brother is a screaming blue flame liberal. He sees the market over 11,000 and touts the recovery is now full steam ahead. I try and reason with him but no, I'm the dope. He went to Harvard Law and I only finished High School. What the hell do I know. Glad I bought gold and silver.

Mon, 10/11/2010 - 23:41 | 642435 Minion
Minion's picture

Liberals think emotionally, that is why they don't act like men.

Tue, 10/12/2010 - 00:28 | 642510 Grand Supercycle
Grand Supercycle's picture

S&P500 Financials index has not been bullish for some time. This is a warning.

http://stockmarket618.wordpress.com/2010/09/27/mon-sept-27

Tue, 10/12/2010 - 06:08 | 642645 shortvols
shortvols's picture

the back far dated futures are a remnant of flash crash. nothing more. there is no smart money who knows something we do not. note next week what will happen to november vix. even on a 4 point vix move up between now and next week ; november will still sell off.

Tue, 10/12/2010 - 07:06 | 642670 Eric Cartman
Eric Cartman's picture

Damn, I can't believe ZH tweets now! This is kinda lame. Mainstream lame.

Tue, 10/12/2010 - 14:45 | 643845 ZeroPower
ZeroPower's picture

What do you mean by 'now'?

Its been quite a while, and yet, i propose to you the tweets simply let us know soon as a new topic is posted. Mainstream? 

Well, you have a facebook dont you? Oh, how mainstream.

Mon, 10/25/2010 - 04:52 | 674558 Eric Cartman
Eric Cartman's picture

You can do get the same thing with google reader and not be a douchebag twitter nerd. But hey, whatever works for you. Tweet away!

Tue, 10/12/2010 - 08:41 | 642774 bada boom
bada boom's picture

Well, if the major players and people as a whole are selling equities for bonds, they no longer need insurance on their stocks. 

 

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