Schaeffer's Trading Floor Blog

Volatility: Where We're Headed Next

Dissecting last week's volatility backdrop

by 3/10/2014 9:14 AM
Stocks quoted in this article:

Another week, another grind higher in the markets. It wasn't without its form of excitement, though. We started out with a panic that Russia's incursion into Crimea would lead us into World War III. Or, something like that. The worries lasted all of about a day, though, and by Tuesday we were making new highs again. And despite some chop, we closed higher each day. Roll it all together and the SPDR S&P 500 ETF (SPY) closed up $1.97 on the week, for a gain of 1.06%. That sounds eh, but if you compounded each week and annualized it, you'd have one great year!

You wouldn't have the greatest year in volatility, though. But don't tell that to the CBOE Volatility Index (VIX). It closed at 14.11, actually up 0.11 on the week. Yes, realized volatility did nudge up a bit to the 10-11 range, but it was more about the Monday-Tuesday whip-o-rama than any indication volatility is actually heading higher.

On the other hand, it's always tough to make the case that VIX at 14 is so fat as to prove unsustainable. I'd have expected to see it drift a little more by now, but I'm not talking a major move. I'd have expected something like 12, so I'd call 14 very slightly high given the backdrop.

The biggest holdout remains the iPath S&P 500 VIX Short-Term Futures ETN (VXX). It's now 32 sessions since it last hit an all-time low. That may not sound like much, but in VXX-world, that's huge. Assuming it hangs in two more days -- and it's a safe assumption, as it would have to break below 40 -- it will mark the longest string without record lows since March-June 2012. And that's hard to believe, as all we saw was a garden-variety dip in late January, and not all that much besides a grind higher ever since.

The term structure in VIX futures has flattened somewhat, but it's still sloped upwards. (Click on the chart to enlarge, courtesy of VIX Central.)

VIX Term Structure

And, as you can see, it's still at a significant premium to VIX itself. There's no reason VIX futures can't overprice versus VIX forever, as there's no locked arbitrage to narrow the gap. We've seen out-month futures carry nice premiums forever, albeit higher ones than we've seen now. I would think at some point, though, there won't be much demand to "lock in" VIX futures 1.5-2 points above VIX for a couple months on the hope that there's a lift that generally doesn't happen. But until then, Rock On VXX!

We're through jobs, and we're discounting Ukraine at this point. We're also a bit away from the big 1,850 magnet in the S&P 500 Index (SPX) now. I'm not sure what the next big driver up in volatility might be, although by definition we're not supposed to know that in advance anyway. But, I just don't see much reason to pay up for any paper now.

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

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