Schaeffer's Trading Floor Blog

Predicting the Next Great VIX Rally

Analyzing the current term structure of the VIX

by 4/7/2014 7:19 AM
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Another week, another churn to nowhere. I have to admit, though, Friday's very ugly reversal and Nazz-inspired sell-off fooled me into thinking we had dipped on the week. I guess I'm getting old, I forgot we acted very well early on and actually hit all-time highs in the S&P 500 Index (SPX).

The SPDR S&P 500 ETF Trust (SPY) dipped 1.2% Friday, but it still managed to eke out a 0.5% gain on the week! But let's face it -- no matter which side you're rooting for, you almost have to go home each Friday disappointed. I mean, we break resistance up above and look ready to go and then it fails. So great news for the bears, except at the end of the week, we never really moved anywhere.

Okay, some sides remain happy. Anyone who just trades futures or exchange-traded funds (ETFs) and goes by the "sell the rips, buy the dips" strategy is likely thrilled this year. I gotta be honest, my skin crawls every time I hear someone say that on TV or tweet it out. As if it's that easy to just trade into every move. It's just not. The "rip" you sold into often becomes the beginning of a trend move. Same as the dip you faded. Just not so far in 2014 they've all become fades before long. But, that won't last forever. The more it churns, the more fading everything will come into vogue, and the more late stragglers into the strategy get burned.

Another side that's done quite well in 2014 is the group that sells options volatility and hedges in an unaggressive manner. Selling gamma, collecting daily premium, and ignoring your options' deltas has to have been a quite lucrative plan so far this year.

The iPath S&P 500 VIX Short Term Futures ETN (VXX) has still kept its head above water. It came within 40 cents of a new low, but Friday's sell-off now has it 2 points away again. CBOE Volatility Index (VIX) futures continued their pattern of gradual flattening. Here's how the term structure went out on Friday, courtesy of VIX Central.

VIX Term Structure

The whole curve is under 18 now, something we haven't seen in a while. There are still premiums across the board, but it's declining.

I mentioned the other day that the first quarter of this year bore some similarity to the first quarters of 2004 and 2007. So I thought to myself, "Hey, I wonder how the term structure looked at the beginning of 1Q 2004 and 1Q 2007."

Unfortunately, VIX Central only goes back to 2007. But the results are quite interesting, nonetheless. Here's our current term structure versus April 2, 2007.

VIX Term Structure

Remember, that's a time with a similar spot VIX and similarly (non-) volatile first quarter of the year.

Slight difference in future volatility sentiment, no? I guess we didn't go as far out in time then, but it doesn't look like that would have mattered. There was just no particular reason to pay up for VIX futures there was no reason to expect an inevitable lift down the road.

The VIX, of course, did rally later in the year, but further out in time than this graph shows.

There's no reason now to pay up, either. Except the market always pays up -- it's predicted the next great VIX rally for almost five years now. Perhaps the market rally will truly end when VIX futures finally give up. We're slowly getting there, but we still have a ways to go.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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