The Cheapest Volatility

The VIX hit its lowest levels since 1993 this week, and that captured headlines. Whats most interesting to me is the spread between realized and implied volatility. Realized shows how much the market is actually moving, whereas implied is what the market thinks volatility will be.  During sudden shocks or crisis’ (BRExit) realized volatility can trade above realized. In normal markets realized is less than implied.

The chart below shows current implied (yellow line) vs realized (blue) in the SPY.  I like to think that (during “normal” markets) when the spread (the gap between the lines) narrows that volatility is “cheap”. For instance December in the chart below. In April there was major hedging of the French elections, so the IV spiked way up. The underlying market however didn’t budge.

SPY IV vs RV

Whats interesting about the current market is that realized volatility is essentially at historic lows. It could drift a bit lower, but its basically on life support. Implied volatility has really dropped after the French election as well, almost to the level of realized. So the situation is that realized is about as low as possible, but implied is right there with it. If they are both literally on the floor there are only two outcomes:

  1. Volatility continues to trade sideways
  2. Volatility gets up off the floor

I am not forecasting impending doom, I am just noting that it seems to me that the risk reward of shorting volatility is not as good as it was a few months ago. So, whether you’re long XIV, short VXX or in variance swaps I’d be cautious.

The “50 Cent” VIX Buyer Doesn’t Care

There is a fair amount of coverage on “50 Cent” the VIX buyer who is offloading cash into VIX calls (generally priced at 50 cents) to the tune of an estimated $80 million dollars.

You don’t get to be in a place where you can lose that type of premium unless you are smart. I don’t think this guy is just ad-hoc betting on a market collapse. I suspect he’s shorting the heck out of volatility ETP’s (UVXY, VXX, etc) or hedging long positions in XIV, SVXY etc.

One of the things that always pops up are headlines reading “RECORD INFLOWS INTO VOLATILITY ETPS – INVESTORS BETTING ON COLLAPSE”. I have not done the math (yet) but, for a thought exercise:

Could the guy plowing unbelievable amounts of money into VIX options be the on the other side of all the retailers plowing unbelievable amounts of money into volatility ETP’s? I think the liquidity is there to offset $80mm in VIX calls…

VOLATILITY ETP INFLOWS
long volatility ETP’s inflows

A Backward Contango

Despite a selloff in volatility land yesterday there is still a strange “backward contango” in VIX futures caused by the French Elections. In normal times you would see “backwardation” in the chart below (blue line). This means the April VIX future woudl have a lower price than May. However April is higher than may, again, most likely due to the French elections. This could work against you if you are using short volatility ETPs and with you if you’re long VXX or another long volatility ETP. Explained here and here.

VIX Contango

Currently according to the VXX website April futures are a very small component of the holdings. As May VIX futures prices are less than spot VIX (green line in the chart above) this means you might not collect on the “reversion” or decay of the futures to VIX. To me this means shorting VXX isn’t as juicy here as 15/16 handle VIX might imply.

VIX Futures Roll

XIV, the short volatility ETF has basically the same futures allocation. Again because of the weird VIX futures curve when you are buying XIV you are long mainly May futures which are less in price than spot VIX. I don’t think this is an advantageous product to use to short volatility at this moment because of this inversion.

XIV allocation

Whats wrong with your Volatility Products (ETPs)

Many who trade in the volatility products (ETF’s and ETN’s etc) do not understand how the products work. If you don’t believe me just spend a few minutes on the Stocktwits VXX feed. Complaints usually relate to “the VIX moved and my [insert VXX, SVXY, TVIX, XIV, etc] didn’t move. This is market manipulation and or conspiracy.” There are dozens of articles about why these things don’t track the VIX, here’s one. What interest me is different.

Embedded in the prospectus of XIV is a clause that allows the ETP provider (Velocity Shares) to effectively terminate the leveraged product if there is “more than an 80% move” in the underlying futures. For leveraged products (i.e. 2x volatility) its only a 40% move. Note: this doesn’t specific DIRECTION it just says MOVE. So you could be correct in the direction (i.e. long XIV when volatility spikes) and still lose. I haven’t looked at other prospectuses, yet.

From the XIV prospectus (gotta love the term “Event Acceleration”):

“Sensitivity of the ETNs to large changes in the market price of the underlying futures contracts Because the Inverse ETNs and 2x Long ETNs are linked to the daily performance of the applicable underlying Index and include either inverse or leveraged exposure, changes in the market price of the underlying futures will have a greater likelihood of causing such ETNs to be worth zero than if such ETNs were not linked to the inverse or leveraged return of the applicable underlying Index. In particular, any significant increase in the market price of the underlying futures on any Index Business Day will result in a significant decrease in the Closing Indicative Value and Intraday Indicative Value of the Inverse ETNs, and any significant decrease in the market price of the underlying futures on any Index Business Day will result in a significant decrease in the Closing Indicative Value and Intraday Indicative Value of the 2x Long ETNs. If the price of the underlying futures contracts increases by more than 80% in a day, it is extremely likely that the Inverse ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration if we choose to exercise our right to effect an Event Acceleration of the ETNs. If the price of the underlying futures contracts decreases by more than 40% in a day, it is extremely likely that the 2x Long ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration. If the price of the underlying futures contracts decreases by more than 80% in a day, it is extremely likely that the Long ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration if we choose to exercise our right to effect an Event Acceleration of the ETNs”

Several years ago there was a class action lawsuit against Credit Suisse due to the rapid decay in their TVIX product.

 

Feb 2012:

“Credit Suisse, the sponsor behind the VelocityShares Daily 2X VIX Short-Term ETN (NYSEArca: TVIX), temporarily suspended creations of shares of the exchange-traded note because assets in the security had grown beyond what the bank, in a press release, called “internal limits.”

This all plays into a future event I see coming which I’ve dubbed “volivator”.

My point is this:

Know what you’re trading – if you don’t understand it then you have no business trading it.

“Forecasting a Volatility Tsunami”

Andrew Thrasher CMT won an award for this paper “Forecasting a Volatility Tsunami” which is about preemptively detecting major moves in volatility. The paper is here. My review/notes are below.

He calls it the “volatility dispersion method”. Essentially he looks at the “20 day standard deviation” (he arrived at 20 days through Bollinger Bands, and notes the time period could be optimized) of the VIX and VVIX and notes that the largest spikes in VIX occur “when price dispersion is extremely low”. He then runs the same excercise with VVIX, creating two “signals” to use marking low “price dispersion”. His theory is that this is a great predictor of an impending volatility spike.

Here is my problem. His data set was May 22, 2006 to June 29, 2016. Why? I don’t know much about the market around May 2006 but I know a lot about June. That was BRExit. His data would catch that volatility event, but ignore the rest of the year.  Also many of the papers and data he cites are very old – he quotes a VIX options volume stat from 2011 (its a 2017 paper). He did use 10 years of data which is quite a lot, so its possible that the rest of 2016 didn’t diminish his signal.

The notable thing about the rest of 2016 was:

  1. Historic levels of calm – “low price dispersion” as Thrasher would call it.
  2. Volatility mean reversion at record speed indicating large demand to sell vol and keep it lower.

So, I’d be very curious to see why he chose those dates. The other stat which he doesn’t mention is realized volatility. I would be curious to see if the “dispersion” measurement would work on the S&P 500 as a whole as well? Several times he notes that there is an “anecdotal belief…that a “low” reading in the [VIX] or a large decline alone are ample reason to believe that volatility will spike in the near future.” Well, whats “low”? To answer that you have to examine realized vs implied volatility levels.

My point is that while this signal could prove useful I wouldn’t take it for anything more than face value. I would also hesitate to base much off of it going forward if the Fed substantially changes its methodology (removal of Fed put) as that type of structural market shift could ruin this signal.

For example, using this signal to buy UVXY or VXX still probably gets you nowhere.

finviz dynamic chart for  VXX