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Artifacts in VIX Futures Curve

With all of the movement in the VIX futures curve and strange supply/demand dynamics, it seems like there are almost always kinks in the curve.  If we look at the current curve, December 2011 VIX futures are trading a bit above 34 while January VIX futures are trading a bit above 35:

 

Kinks in the VIX futures curve

There is no guarantee that this difference will not widen or stay this way for a while, but it seems nearly definite that the gap will close at some point as the curve settles down.  You could short the January VIX futures and buy the December 2011, but at $1,000 per point this might be too large of a trade for most.  Alternatively, options on the VIX can be traded in contracts which are $100 per point.   Many combinations of trades could capture a shrinking of the Dec/Jan gap.

Posted in Markets, Trading Ideas.

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By SurlyTrader – October 5, 2011

VXX Outperforms the VIX

There are numerous articles on the profitability in shorting the Ipath S&P 500 VIX Short-term Future Exchange traded note, A.K.A VXX.   Some investors who thought this was a fool-proof strategy will be scratching their heads about the stellar two month performance of VXX:

 

VXX outperforms the VIX!

The key performance reasons have been 1) rising levels in all of the VIX futures contracts and 2) the movement from contango to backwardation.

When the VIX futures curve is in contango, the VXX ETN continously buys a futures contract that ages, rolls down the curve, and loses value.  When the VIX futures curve is in backwardation the opposite process happens – the ETN buys a futures contract that ages, rolls up the curve, and gains value.

By looking at the last two month spread between the 4th month and 1 month VIX futures contract, we can see that there has been strong backwardation since the beginning of August:

 

Backwardation shown in the VIX futures spread between 1 month and 4 month

The good news if you are short: these periods of backwardation have always reverted to contango in the past and there is no reason that we should expect this time to be different.

Volatility cannot stay at 45% because there would be very few equity investors left to trade if daily moves were expected to be in the 3%+ range.  Even the black boxes need investors to backstop their losses…

 

Posted in Derivatives, Markets.

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By SurlyTrader – October 4, 2011

Contagion Risk for US Banks

The European crisis has spread quickly over the last few weeks to global markets.  The S&P 500 shaved 2.85% today and closed at its 52 week lows.  The bigger news is that US banks have become a larger target of exposure rumors.  Morgan Stanley has quickly grabbed the headlines with a fervor that trumps Bank of America:

US Bank credit spreads at crisis levels

To put Morgan Stanley’s credit spread in perspective, it is now wider than Italian banks.  These spread levels indicate collapsing confidence in the US banking system that can become a self-fulfilling prophecy.  With equity markets down so sharply and financial institutions in the gun sights again, I can only imagine that the Fed and the Treasury are looking at a new plan to calm the markets.  The last thing that we need is the global financial crisis redux.

Posted in Markets, Politics.

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By SurlyTrader – October 3, 2011

Noteworthy News – October 3, 2011

Economy:

U.S. Economy Tipping into Recession – ECRI

How North Dakota Became Saudi Arabia – Wall Street Journal

How Did the Robot End Up With My Job? – New York Times

Markets:

The emerging markets are winning the currency war – Economist

Stocks Log Worst Quarter Since ’09 – Wall Street Journal

IPOs Shelved at Record Pace as Offer Pipeline Balloons – Bloomberg

Politics:

Greece to miss deficit targets despite austerity – Reuters

Unless politicians act more boldly, the world economy will keep heading towards a black hole – Economist

Banks:

The Bankers and the Revolutionaries – New York Times

Buffett Takes His Case to Wall Street – Dealbook

Reaction to BofA’s Proposed New Debit Card Fee – New York Times


Posted in Economics, Markets, Media, Politics.

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By SurlyTrader – October 2, 2011

Volatility Losing Steam?

One common misconception is that the widely followed volatility index, the VIX, will hit its peak when the market bottoms out.  This is not usually the case.  I like to think of the VIX as a measure of uncertainty.  When bad news comes out, the VIX moves upward to indicate the future uncertainty of the market and the future uncertainty of just how pervasive that bad news is.  It is almost always the case that the market will move downward when the VIX spikes or vice versa, but the relationship breaks down after time allows information to be disseminated and future risk to be assessed.  In the case of the global financial crisis of 2008, the uncertainty about the magnitude of the crisis hit a max in November of 2008 whereas the market bottom was reached almost 3 1/2 months later in March of 2009.  With the European risk flare of 2010, we saw the VIX uncertainty peak out in May with a market bottom hit in July:

VIX leads the charge, followed by VIX futures, then the S&P 500

I believe the fact that the VIX has made lower highs over the last few months is a good omen for volatility peaking out.  We might see the VIX spike back up to its August peak as the market breaks down below its previous lows, but I doubt it will go much further.  I am also happy to see that the 4th VIX futures contract, represented by “UX4” above, is getting close to its 2010 highs.  I believe that the next week or so will provide a good opportunity to get short volatility.

With regards to the massive peak in volatility reached in 2008, as I have stated in prior posts, I do not believe that we will witness a complete financial freeze up like we saw in 2008.  This is an opinion and not a 99.9% confidence interval statement.  If there is one thing that 2008 should have taught you as a trader:  that you should leave your pride at the door.  Always make sure that you can survive the worst case scenario either through purchasing protection or correct position sizing.

We are two months into a market cycle that really has provided little *new* bad news.  A very ugly GDP number tomorrow or large confirmation of a double dip recession could change that significantly.

Posted in Derivatives, Markets, Trading Ideas.

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By SurlyTrader – September 28, 2011

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