E 2018 Market Volatility And Volatility Trading Update

Contango and Backwardation

For those new to trading volatility, understanding term structure is of critical importance as it can point to the current and implied state of market volatility out 8 months. Vixcentral.com is a useful resource for studying term structure and aspects of contango and backwardation.  The state of term structure is found in contango more than 85% of the time. Below is a screenshot of Finomgroup.com’s 4-part VIX course slide that identifies the history of contango vs. backwardation.

  • When a market is "in contango," it describes a situation in which the delivery price of a particular futures contract has to converge downward to meet the spot price. A market that is in contango indicates that the forward or futures curve is upward sloping. If prices did not converge, it would set up an opportunity for investors to profit from arbitrage. Contango situations can be costly to investors holding net long positions since futures prices are falling. We typically suggest that when contango is present, there is a headwind for long VXX/UVXY holdings.
  • Backwardation does not occur frequently in the Volatility complex based on the natural order of market cyclicality being more predisposed to bullishness than bearishness. When the Spot Price/VIX of the underlying is greater than the futures price at a particular point in time, the situation is called “backwardation”. When VIX futures are in backwardation, the futures price moves higher to converge with the Spot Price in backwardation and as the futures contract approaches expiration. We typically suggest that when backwardation is present, there is a tailwind for long VXX/UVXY holdings.

The following image shows both conditions of the VIX futures curve or term structure. While the curve is upward sloping, denoting contango, the front two-month futures contracts are in backwardation.

As noted earlier, 2018 has been found with elevated levels of volatility when compared to 2017. Given such a dynamic, backwardation has also been more prevalent in term structure. Contango represents the implied stability in the marketplace, or complacency. Backwardation tends to represent rising volatility and greater fear in the marketplace.

Fed Tightening and Volatility

In speaking of 2018 and market experience, how does Fed-tightening factor into the equation? That’s a very good question, a very good question indeed. As we consider Fed tightening through the prism of the yield curve we’re forced to accept and understand that, well this is a time where experience may be helpful but a guide it may not prove to be. Why? Well because there has never been such a tightening cycle coinciding with such fiscal stimulus in the means of tax reform, or for that matter following such a long cycle of quantitative easing. These are new issues and experiences the market is and will contend with going forward.  Emerging markets are presently feeling the brunt of U.S. central bank tightening and decoupling economic growth prospects.  Central bank tightening has already served to impact investor sentiment as we noted earlier as well.  As such, forecasting volatility may require more erring on the side of caution rather than sticking to hard and fast notions of predictions and modeling.

Nonetheless, modeling is not without its merits in both form and function. Take a look at the recent model produced by Topdown Charts:

“The chart comes from a report on the yield curve outlook and the implications for risk assets. Basically, our analysis shows that this flattening of the yield curve will not slow down any time soon, and if anything, we expect the yield curve to fully invert within the next 6-12 months.

At the long end of the curve, bond market participants are constantly discounting information and expectations about future growth and inflation. As you get closer to the end of the business cycle, naturally this would mean that 10-year bond yields would start to top out or even fall as bond traders anticipated softer data ahead, thereby driving flattening by keeping 10-year bond yields constant if not pushing them lower.

So on the back of this chart, it's entirely reasonable to expect volatility to be generally higher and to trend upward over the next couple of years.”

While the exercise and provided chart are offered in modeling future potential for both the spreads and VIX, it has it’s shortcomings and it’s probably more optimal to model the flatness of the curve than perform a comparative analysis and projecting onto the VIX.  

Bottom line is that most late inning expansion cycles are comprised of higher volatility levels. As such a short-VOL trader will find it increasingly more necessary to monitor aspects of liquidity in the trade and likely take smaller bites in favor of maintaining longevity in the trade. For example: Let us say we can see into the future and we see that the VIX will average 17% in 2019. This is possible and has a greater probability given the aforementioned factors consistent with a late inning market cycle. Does that mean the VIX will be between 19% and 15% for the duration of 2019? Certainly not. There will likely be periods above 20% and below 14%, but it’s within these ranges that volatility traders will need to make decisions on shorting, taking profits, deleveraging and standing by while things essentially play out. This is where mentors can come in quite handy.

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