We have seen the SPX futures fall by some 2.5% since the close 2 days ago. Although we are trading at late October lows, VIX has spiked, but not as dramatically as we saw it spike earlier this fall. The sell-off earlier this October was more violent than these last 2 days of markets moving lower.
Back in late October, we argued that the market was pricing VIX with relatively too much “panic” component and we argued for VIX having gone ahead of itself during those spikes reaching VIX levels of 27/28. We explicitly said that buying VIX at 27/28 is an expensive hedge. What happens in “classical” panic moments is that investors tend to confuse pace with direction, leading people to overpay for protection.
The inverse happens in times of long periods with calm markets when people “forget” that markets can be volatile. We warned of such complacency had reached markets in October, just before the sell-off started, and argued that VIX was probably the world´s best global hedge in our post from October 2nd. Back then VIX shorts was a popular crowded trade among those investors picking up dimes in front of the steamroller, that later in October blew up.
(Latest casualty among options sellers blowing up is optionsellers.com that according to Bloomberg have been caught wrong in the latest natural gas moves.)
Let´s move to some current observations on volatility. Note in the below chart how the net short VIX (net non-commercial futures), orange line, have shifted from very short to being net long here.
In times of volatility stress, the risk manager takes control of the book many times, and simply orders for losing short volatility trades to be closed out. (Ironically, many times the “smart” quants on the desk start explaining this is a “paradigm” shift in volatility, leading to people reversing short volatility positions to even long volatility strategies. What people tend to forget, these same smart guys said sell volatility because it is not moving, only to revert the same argument to buy volatility, the market is moving.)
Note below that during VIX spikes that eventually were accompanied with spikes in VIX positioning actually marked local highs for volatility. Positioning in VIX futures is a simplified view on aggregate vol positioning since VIX futures can be used for hedging and offsetting other short volatility positions, but nevertheless, it shows a fair aggregate picture.
Below is the term structure of the SPX index. The current look of the curve is the orange line, 1 week ago the green line and blue representing the curve 2 weeks ago (“normal” looking slope). We can clearly see short-term maturities are relatively more “bid” than longer-dated maturities. This happens in terms of sharper moves to the downside for equity markets.
Below chart shows the spread between the first month VIX future versus the 6-month VIX future. Note that the spread is positive by almost 2 points here, meaning front month VIX trades 2 points above the 6 months VIX future. This shows there is (still) stress in the system, despite the fact VIX hasn´t spiked as high as we saw it during the October sell-off. When markets are calm the spread trades negative as you can see by the chart. In times of stress, the spread trades positively, just as we have seen it since October. In order for “properly” calm markets to resume (when and if) this spread needs to go negative again.
Be sure to watch the above two charts for “clues” on volatility, and not only watch the VIX itself.
The following chart shows the SPX (orange) and the CBOE put call ratio (white). Spikes in put-call ratio is basically telling us investors are buying more puts relative to buying calls. In terms of sharp sell-offs the ratio tends to spike higher as people buy protection (often too late).
Note how big spikes in the put-call ratio over the years have been marking local lows for the SPX. It would be naïve to call the lows here, but given the fact fear and stress are high, why not a sudden reversal higher in equities, if nothing just to confuse everybody once again.
For full reading on VIX and how it is priced visit CBOE.
Source: charts by Bloomberg
