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