Inside Volatility Trading: "What — Me, Worry?"

Kevin Davitt

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January 28, 2020

On the December 1956 cover of Mad Magazine, Alfred E. Neuman made the first of his many appearances as a write-in candidate for President of the United States. As one of the longest running satirical publications in US history, the writers of Mad Magazine both parodied and captured the omnipresent state of uncertainty.

In capital markets, some degree of worry is inevitable. Market practitioners and talking heads often reference the "wall of worry" that equity and fixed income markets constantly confront. More specifically, the collective perception of risk is often best reflected through price discovery in the derivatives markets.

S&P 500® Index (SPX) options combined with the VIX® Index and (VIX®) futures term structure are direct reflections of market sentiment at any point in time.

In the previous Inside Volatility newsletter, attention was focused on “tenors” and duration risk. The typical VIX® term structure is referred to as contango. Longer dated VIX® futures contracts tend to trade at a premium to short-dated futures. During periods of market duress the VIX® curve may flatten and/or invert (backwardation).

Sources: Wikipedia and MAD

Source: LiveVol Pro

The VIX® futures curve is currently in its more typical state of contango. The S&P 500® has marched steadily higher since early October lows (+16%). There’s been a distinct lack of broad market volatility over the past 3 months. The last SPX® close-over-close advance of 1% or more occurred on October 11th. ** The last single day decline of more than 1% happened 74 trading days ago on October 8th.**

The average (absolute value) daily change in the SPX since October 11th is a miniscule 0.368%. 20-day SPX® historical vol (white line) has been vacillating around the 7% level. The 100-day historical vol (purple line) reading of just over 9% is the lowest since October of 2018. On January 17, the VIX® Index closed at the lowest level since the day before Thanksgiving.

Source: Bloomberg

The market has seemingly been saying “What, Me Worry?”, but there’s one big caveat and a few smaller ones on the horizon. Volatility and Index option markets term structures seem to be expressing fairly significant levels of uncertainty in the March and November expiries because of the US Presidential Democratic nomination process and the US Presidential election, respectively.

On November 3, 2020 an estimated 50%-60% of eligible U.S. voters will turn out for the next Presidential (and Congressional) election. With the derivative markets saying something like, “What, well…..maybe I’m a little worried”, let’s take a look at how you might interpret the data.

Keep in mind that the VIX® Index and futures, like any forecast, can change in fairly short order.

VIX® futures are (30-day) forward looking products. To illustrate, the (standard) February VIX® futures contract that expires on February 19th is reflective of expected volatility 30 days later (March 20th). As such, the October VIX® futures are a glimpse at expected implied volatility levels in November.

More accurately, the VIX® futures market has been pricing in greater uncertainty during the November expiration cycle relative to all others.

Source: Cboe Futures Exchange

The chart above is very instructive. The visual illustrates the current VIX® term structure. The most prominent point is a kink in the curve for the October futures* contract. There’s also a less prominent steepening in early February and March. There appears to be a corollary between potential future volatility and the Iowa caucuses and/or “Super Tuesday” primaries.

Evaluating, some historical market data on CFE, there was a significant jump in long-dated futures open interest between January 7th and 8th. Based on trade data it appears that a market participant(s) was executing the Sept/Oct/Nov VIX® futures butterfly. The spread between September and October futures is currently about 2.35 (October over). A “normal” spread for the month 8 vs. month 9 spread would be around 0.15 (month 9 over).

The relationship between volatility markets and the electoral cycle deserves attention in the coming weeks and month.

With the S&P® 500 seemingly unaffected by political uncertainty in late January, it appears that Alfred E. Neuman remains inimitable with his catchphrase.

If you’re interested in learning more about VIX® futures and options as risk management tools click here.

*October and November VIX futures were listed ahead (Dec 9) of their typical cycle because of end user requests and potential Election driven uncertainty.

** Data is as of January 23

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