Potential VIX Breakdown Near-Term Opportunity For Equity Bulls, But Volatility Curve In Contango Medium-Term Risk

VIX is on the verge of a breakdown. After sustaining over 20 for a year, it risks losing that level in the sessions ahead. A decisive breach opens the door toward mid- to high-teens near term. This will have taken place at a time when several other metrics are screaming caution medium term.

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For the first time since February 24 last year, VIX (19.97) closed under 20 last Friday. Back then, the volatility index printed higher lows for over two months before breaking out of low-20s and ultimately peaking at 85.47, which was the second highest print ever (VIX).

This time, too, VIX made higher lows since late November last year. Volatility bulls’ attempt to rally off of it got capped at 37.51 late January. The drop from that high has been quick, with a slight breach of the trend line.

More importantly, a decisive breach of 20 opens the door toward mid- to high-teens, where VIX routinely found itself in before last February’s breakout. For months, the index remained suppressed in 10-11, with a record low of 8.56 in November 2017 (arrow in Chart 1).

In essence, VIX went from north of 37 to sub-20 in merely two weeks. The speedy drop has emboldened the bears. In the futures market, non-commercials as of last Tuesday were sitting on 138,317 net shorts in VIX futures, which was the highest since late January last year (Chart 2).

So far this year, these traders have gradually added to their holdings. At the end of last year, they were net short 98,550 contracts. VIX was 22.75 then. Directionally, they are on the right track and will do well once VIX decisively breaches 20 and heads toward its prior comfort zone.

In this scenario, the volatility curve could steepen a little bit more, as premium continues to come out faster in the short end.

VIX measures expectations for 30-day volatility using S&P 500 options. VXST does the same but only goes out to nine days, VXV to 90 days and VXMT to six months. The curve already is in contango.

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