VIX and More

[The following originally appeared in the November 2012 edition of Expiring Monthly: The Option Traders Journal. I thought the contents might be timely in light of the upcoming holiday season.]

With fewer trading days and a historical record that favors an uptick in stocks and a downtick in volatility, the end of the year never fails to present an intriguing set of trading opportunities.

One phenomenon related to the above is something I have labeled the “holiday effect,” which is the tendency of the CBOE Volatility Index (VIX) December futures to trade at a discount to the midpoint of the VIX November and January futures.

This article provides some historical analysis of the holiday effect and analyzes how the holiday effect has been manifest and evolved over the course of the past few years.

Background and Context on the Holiday Effect on the VIX Index

Part of the explanation for the holiday effect is embedded in the historical record. For instance, in eight of the last twenty years, the VIX index has made its annual low during the month of December. In fact, the VIX has demonstrated a marked tendency to decline steadily for the first 17 trading days of the month, as shown below in Figure 1, which uses normalized VIX December data to compare all VIX values for each trading day dating back to 1990. Not surprisingly, those 17 trading days neatly coincide with the typical number of December trading days in advance of the Christmas holiday.

{Figure 1: The Composite December VIX Index, 1990-2011 (source: CBOE Futures Exchange, VIX and More)}

Readers should also note that, on average, the steepest decline in the VIX usually occurs from the middle of the month right up to the Christmas holiday.

The December VIX Futures Angle

Most VIX traders are aware of the tendency of implied volatility in general and the VIX in particular to decline in December. As a result, since the launch of VIX futures in 2004, there has usually been a noticeable dip in the VIX futures term structure curve for the month of December. Figure 2 below is a snapshot of the VIX futures curve from September 12, 2012. Here I have added a dotted black line to show what a linear interpolation of the December VIX futures would look like, with the green line showing the 0.50 point differential between the actual December VIX futures settlement value of 20.40 on that date and the 20.90 interpolated value, which is derived from the November and January VIX futures contracts. (Apart from the distortions present in the December VIX futures, a linear interpolation utilizing the first and third month VIX futures normally provides an excellent estimate of the value of the second month VIX futures.)

{Figure 2: VIX Futures Curve from September 12, 2012 Showing Holiday Effect (source: CBOE Futures Exchange, VIX and More)}

Looking at the full record of historical data, the mean holiday effect for all days in which the November, December and January futures traded is 1.87%, which means that the December VIX futures have been, on average, 1.87% lower than the value predicted by a linear interpolation of the November and January VIX futures. Further analysis reveals that on 91% of all trading days, the December VIX futures are lower than their November-January interpolated value. The holiday effect, therefore, is persistent and substantial.

The History of the Holiday Effect in the December VIX Futures

Determining whether the holiday effect is statistically significant is a more daunting task, as there are only six holiday seasons from which one can derive meaningful VIX futures data. Figure 3 shows the monthly average VIX December futures (solid blue line) as well as the midpoint of the November and the January VIX futures (dotted red line) for each month since the VIX futures consecutive contracts were launched in October 2006. Here the green bars represent the magnitude of the holiday effect expressed in percentage terms, with the sign inverted (i.e., a +2% holiday effect means that the VIX December futures would be 2% below the interpolated value derived from November and January futures.)

{Figure 3: VIX December Futures Holiday Effect, 2006-2012 (source: CBOE Futures Exchange, VIX and More)}

Conclusions

With limited data from which to draw conclusions, it is tempting to eyeball the data and look for emerging patterns which may repeat in the future. Clearly one pattern is that an elevated or rising VIX appears to coincide with a larger magnitude holiday effect, whereas a depressed or falling VIX is consistent with a smaller holiday effect. The data is much less compelling when one tries to determine whether the time remaining until the holiday season has an influence on the magnitude of the holiday effect. While one might expect the holiday effect to become magnified later in the season, the evidence to support this hypothesis is scant at this stage.

To sum up, investors have readily accepted that a lower VIX is warranted for December and the downward blip in December for the VIX futures term structure reflects this thinking. As far as whether this seasonal anomaly is tradable, there is still a limited amount of data – not to mention some highly unusual volatility years – from which to develop and back test a robust VIX futures strategy designed to capture the holiday effect.

In terms of trading the holiday effect for the remainder of the year, the coming holiday season is also complicated by matters such as the fiscal cliff deadline and various euro zone milestones that are set for early 2013. In fact, there may not be a reasonable equivalent since the Y2K fears in late 1999 that turned out to be a volatility non-event when the calendar flipped to 2000.

While the opportunities to capitalize on the 2012 holiday effect may be difficult to pinpoint and fleeting, all investors should be attuned to seasonal volatility cycles as 2013 unfolds and volatility expectations ebb and flow with the news cycle as well as the calendar.

Related posts:

• December Is the Cruelest Month…For the VIX
• VIX and the Week Before Christmas
• Chart of the Week: Historical Volatility Plummets in Seasonal Swoon
• VIX Holiday Crush

Other articles republished from Expiring Monthly:

• Volatility During Crises
• Cheating with Partial Hedges
• The VIX-VXX Minotaur Trade
• The Education of a Trader

Disclosure(s): none

Even with the U.S. fiscal cliff grabbing all the headlines and keeping the VIX from dipping under 15, I still thought I might be able to trot out my annual series of posts on the holiday effect (or calendar reversion):

• December Is the Cruelest Month…For the VIX
• VIX and the Week Before Christmas
• Chart of the Week: Historical Volatility Plummets in Seasonal Swoon
• VIX Holiday Crush

As it turns out, fears related to the fiscal cliff have trumped the seasonal factors – at least so far – and the VIX futures term structure has twisted and turned in a decidedly unusual manner.

The graphic below shows the VIX futures term structure curve from November 27^th (dotted red line) and again today (solid blue line), eight trading days later. Typically when there are changes in the term structure, the most extreme moves are in the front month (Dec) contract, the second largest move is in the second month (Jan) contract and so on down to the back month, which typically moves only about one third as much as the front month.

What makes the graphic below so interesting is that the front month contract is up slightly (actually up 0.05 points) while the market’s estimation of future implied volatility going out all the way to August has dropped at least 2.2% (Jul and Aug) and as much as 3.8% (Feb). What can we conclude about these changes in the VIX futures? Well, most likely investors are buying protection against a move in December (the VIX futures expire at the open on December 19^th) and are selling longer-dated VIX futures contracts for February and other months in order to finance the cost of that protection. All things being said, the market is reflecting less risk in 2013, somewhat offset by a slight increase in risk and uncertainty for the next two weeks or so.

[source(s): CBOE Futures Exchange (CFE)]

Related posts:

• The 2012 VIX Futures Term Structure as an Outlier
• Violent Disagreement Across VIX Futures
• Tracking the Fall in VIX Futures
• Third Steepest First-Second Month VIX Futures Contango Ever
• VIX Futures: A Tale of Two Backwardations
• New VIX Backwardation Record
• VIX Backwardation Commentary
• VIX Term Structure Evolution Over Last Ten Days
• Capitulation in Back Month VIX Futures
• VIX Futures: What Were/Are They Thinking?
• VIX Term Structure Changes Since November 20th
• Monitoring VIX Futures and Their Impact on VIX ETPs
• VXX Calculations, VIX Futures and Time Decay

Disclosure(s): none

The last four days have seen a dramatic decline in all things related to the VIX. The cash/spot VIX is down 26% from last Wednesday’s close as I write this and the VIX futures have followed the VIX down to varying degrees. The graphic below shows the changes in all the VIX contracts during the last four days – a period during which the entire VIX futures term structure has fallen sharply.

As is usually the case, the decline in the front month (June) contract is the sharpest of the group and has actually exceeded the decline in the cash/spot VIX during the same period. With the June contract set to expire at the open of trading tomorrow, it is not surprising that the contract have been as volatile as the VIX index in the last few days. Note that at the other end of the term structure, the back month (February 2013) VIX futures contracts have fallen only 6.8%, about ¼ of the decline seen in the front month futures. Given where we are in the current expiration cycle (right at the very end), the changes in the other months relative to the front month VIX futures are in line with historical norms.

Sharp-eyed readers will no doubt note evidence of the Holiday Effect in the dip in the December contract, where fewer trading days and bullish seasonal factors have a tendency to dampen volatility – and volatility expectations. [Which raises the question of whether the European sovereign debt crisis and the U.S. fiscal cliff will observe the holidays this year, but that is a post for another time…]

The bottom line is that even with the VIX hovering around the 18.00 line, investors are still anticipating a VIX in the 29-30 range for the beginning of 2013. While this may sound high to some, it is down from expectations of a VIX of 31-32 just last week.

One thing I am certain of: there will be a fair amount of entertainment value just in watching the gyrations of the financial markets for the next few quarters. One other thing I am nearly certain of: when the VIX futures make big moves, new opportunities are bound to arise.

Related posts:

• VIX Futures: A Tale of Two Backwardations
• Third Steepest First-Second Month VIX Futures Contango Ever
• New VIX Backwardation Record
• VIX Backwardation Commentary
• VIX Term Structure Evolution Over Last Ten Days
• Capitulation in Back Month VIX Futures
• VIX Futures: What Were/Are They Thinking?
• More Volatility + Less Fear = Lower VIX?
• VIX Term Structure Changes Since November 20th
• The Year in VIX and Volatility (2011)
• Monitoring VIX Futures and Their Impact on VIX ETPs
• New and Noteworthy: VIXcentral.com
• December Is the Cruelest Month…For the VIX

[source(s): CBOE, Interactive Brokers]

Disclosure(s): the CBOE is an advertiser on VIX and More

[The following first appeared in the December 2010 edition of Expiring Monthly: The Option Traders Journal. I thought I would share it partly because I have an article, “Synthetic Seasonal VIX-VXX Arb,” which appears in the just published January 2012 issue of Expiring Monthly that expands upon some of the ideas presented below.]

Rationale

In Greek mythology a Minotaur was a hybrid creature with the body of a man and the head of a bull. Such a creature provided the inspiration for a pairs trade involving short VXX at-the-money calls and long VIX at-the-money calls.

The holiday season has a shortage of trading days and a history of a bullish bias. As a result, December VIX futures have a tendency to remain relatively muted when compared to January VIX futures. Assuming I am able to establish this position for a net credit, a seasonal play on volatility involving short VXX calls paired with long VIX calls has an opportunity to profit if any one of three critical factors dominates:

1. volatility declines and both options expire worthless
2. the VIX futures remain in contango
3. volatility spikes and the VIX is more sensitive to the spike than VXX

It is possible to back test this strategy, but sometimes I like to put the trade on, see how it develops and get a sense of some of the potential hurdles. I fully understand that the results will not be statistically significant and making any inferences about a strategy from one trade is dangerous, but I do find some value in what I call these “proof-of-concept” trades with real money.

With most trades, achieving maximum profitability at minimum risk is the only goal. With a proof-of-concept trade, profits are important, but so is information. For this reason, I have a tendency to leave proof-of-concept trades on longer than I would when trading with an established strategy.

In terms of ratios, my intent is to keep this simple. The VIX is trading at just under 49% of the VXX at the moment and my research indicates that VXX generally moves about 48% as much as the VIX on a daily basis, so with the VIX at about 22 and VXX at about 45, I elect to do this pairs trade on a 1:1 ratio basis, using 10 contracts of each to keep the math simple.

Setup and Entry

In a world of maximum profitability, I would probably wait for some sort of relatively high VIX level before entering this trade, but because I am also focusing on the informational value of the trade, I choose to open the position early in the trading day on November 22^nd, with the VIX at about the middle of its 10-day range.

With the VIX at 22.03 and VXX at 44.98, there is a strong temptation to stay strictly at the money and short the VXX December 45 calls while going long the VIX December 22 calls. For ten contracts, the potential profit should both options expire worthless is less than $1000. Given my expectations for seasonally low volatility and also given the high level of contango in the VIX futures, I elect to shave the odds a little and short the slightly in-the-money VXX December 44 calls and go long the VIX December 22 calls. This raises the potential profit if both options expire worthless by another $200. After trying to work the order a little, I relent and take what the market gives me, recording slippage of $175 on the VIX side of the trade and $100 on the VXX side of the trade. I still manage to pocket $800 on the trade, which leaves me long VIX December 22 calls for 2.30 and short VIX December 44 calls for 3.10.

Position Management

The first important point to keep in mind while managing these two positions is that they run on different expiration cycles. The VIX options expire on December 17^th and the VXX options expire five days later on December 22^nd. For that reason, I anticipate that I will exit the position no later than December 16^th, which is the last day the VXX options are traded.

Monday, November 22 – As luck would have it, the VIX fell 8.3% between the time the trade was executed and the end of the day, pushing both calls out of the money and securing a $500 profit for the position.

Tuesday, November 23 – The VIX reversed to the upside today and is now 0.60 higher than when the VIX calls were purchased. VXX lagged during today’s spike and is 0.06 below where it was when the VXX calls were sold. The relative weakness in the VXX sounds positive for my position, but VXX calls jumped 64% today while the VIX calls rose only 39%. The profitability of trade has turned from +$500 to -$175 in 24 hours.

Monday, November 29 – After some seesaw action immediately before and after Thanksgiving, the weekend saw the Irish bailout formalized and tensions heating up on the Korean Peninsula. Both the VIX and the VIX December (front month) futures closed near the 21.50 level, while VXX spiked up to 46.10. The VIX calls and VXX calls are both in the money and my position is now down $475 in one week. I am now the beneficiary of $36 of theta each day, but I am disappointed that the VIX spike has had more of an impact on the VXX calls than the VIX calls.

Tuesday, November 30 – The VIX closed at 23.54, its highest closing level since September, as concerns lingered about the future of the euro zone and the Koreas. My VIX long calls are now 15% in the money and my VXX short calls are 10.7% in the money, yet the VXX calls continue to be more sensitive to increases in volatility. Today the VXX calls jumped 62% while the VIX calls rose 54%. The position lost $975 today and is now down $1450 in aggregate. If this were not a proof-of-concept trade I would either be exiting the trade or making adjustments to limit risk at this stage. As it is, I will let the trade ride, as my preferred indicators suggest the VIX is ‘overbought’ and is ripe for some mean reversion. My $36 of theta is just a drop in the bucket now.

Wednesday, December 1 – Today was a huge turnaround. The VIX fell 10.2% and VXX declined only 5%, yet the VXX calls lost 50% of their value while the VIX calls dropped only 27%. The result saw the position swing $2000 to a gain of $550.

Friday, December 3 – After falling more than 10% on both Wednesday and Thursday, the VIX fell another 7.7% today, as geopolitical and macroeconomic concerns faded and were replaced by a rising sense of optimism. Over the course of three days, the VIX has fallen 23.5% from 23.54 to 18.0 while VXX has fallen 16.2% from 49.29 to 41.30. With both calls well out of the money and the aggregate gain in the position up to $825 (above the $800 profit target), here is where I would exit the position and lock in profits, but this is a proof-of-concept trade, so I will let it ride…

Friday, December 10 – The graphic below details the full lifecycle of this trade, which is coming to an end today. Of notable interest, during the last week the VIX was relatively steadfast, while VXX lost significant value due to negative roll yield and a general drop across the VIX futures term structure. The result is that VXX, which was 2.1% in the money when the calls were shorted is now 15.4% out of the money, with the calls fetching only 0.15. The VIX has fared much better, starting out 0.1% in the money and now 13.6% in the money. Due to the greater volatility of VIX options and also the extra five days in the VIX expiration cycles, the calls still hold a value of 0.55. For the last three days, the position has been registering a profit in the $1150-$1200 range. As this is almost certainly going to be whittled back to $800 in the 1 ½ weeks until expiration, I am electing to pull the plug on this trade.

Epilogue and Takeaways

The first key takeaway is that with a little patience, a VIX Minotaur trade with a net short VXX position can indeed be profitable. On the flip side, this trade can be highly volatile and requires that significant attention be given to risk management. In anything other than a proof-of-concept environment, I would have exited this trade for a loss long before it had a chance to work its way back to profitability.

I was a little disappointed that the VIX spike did not provide the same lift to VIX options that it did to VXX options. This was due to the fact that VXX options turned out to be much more sensitive to changes in the underlying than VIX options, which is a key learning. Future trades should attempt to establish whether this is a persistent theme.

Another important consideration is the timing of the two expiration cycles. In this instance the position benefitted from the fact that VIX options expiration was after VXX options expiration. In August and September VIX options expired before VXX options, so I would have expected a more challenging environment for this trade during those two expiration cycles.

Future efforts may wish to tweak the degree to which both the VIX and VXX options are out of the money and also adjust the units in the ratio to give a higher weighting to VIX options.

Finally, score one point for the proof-of-concept trade. When real money is on the line, perceptions are more acute, emotional responses and their interaction with the trade are more realistic and ultimately any lessons learned are more deeply etched in the trading psyche.

Related posts:

• VIX Exchange-Traded Products: The Year in Review, 2011
• Chart of the Week: VXX Celebrates 2^nd Birthday
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• VXX Monthly Performance
• Chart of the Week: VXX Celebrates One Year of Futility
• Managing Risk with a Short VXX Position

Disclosure(s): short VXX at time of writing; I am one of the founders and owners of Expiring Monthly

With the political season heating up, it seemed like an opportune time to work “normalcy” into one of my posts again and what better way to do that than by putting under the microscope one of my favorite overlooked indices: the CBOE S&P 500 3-Month Volatility Index, which I typically reference with the more pithy VXV ticker symbol.

For those not familiar with VXV, I am fairly sure I was the first person to discuss this index back in 2007, talk about the merits of the VIX:VXV ratio (which is a great way for someone without VIX futures quotes to keep on top of the VIX futures term structure), devote an entire Barron’s column to the subject (Take a Longer View on Volatility) and promote VXV as a better reflection of long-term and structural/systemic volatility than the VIX, which is better suited to measuring short-term event volatility.

For those who desire some additional background and context, there are shiploads of prior posts on the subject and the links below should provide for some excellent jumping off points.

Getting back to VXV, I think it is important to note that while the VIX remains above its December lows, VXV has now moved below those lows and it plumbing levels that have not been seen since early August – and as VXV is a better gauge of structural and systemic risk than the VIX (not to mention largely untouched by the holiday effect), I think this is an important development to watch.

Frankly, the VXV chart looks a lot like it did back in early April 2009, when I penned Chart of the Week: VXV and Systemic Failure.  At that time I concluded, “The key takeaway: systemic healing is continuing and the risk of systemic failure is diminishing.” Based on the VXV chart, it appears as if we are at a similar moment in time right now.

Related posts:

• Chart of the Week: VXV at Critical Juncture
• Take a Longer View on Volatility (Barron’s)
• Chart of the Week: VXV and Systemic Failure
• The VXV and Extreme Structural Volatility Risk
• The VIX, VXV and Volatility Expectations
• How to Create Your Own Portable VXV
• Thinking About VXV
• A Conceptual Framework for Volatility Events
• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• The VIX, VXV and Volatility Expectations
• The VIX:VXV Ratio
• Normalcy Again? VWSI at –4
  
  

[source(s): StockCharts.com]

Disclosure(s): The CBOE is an advertiser on VIX and More

Last year I talked about the St. Louis Fed’s Financial Stress Index (which I am calling the STLFSI in order to lower my carpal tunnel risk) as a measure of financial market risk that I consider complementary to the VIX and in some cases perhaps even a superior alternative.

Given the fact that some investors have difficulty coming to terms with the “holiday effect” and the seasonal swoon in the VIX, I thought it might be timely to update a chart I have posted here previously which captures the movements in the more broad-based STLSFI. Note that the chart dates from January 2007 and includes all the data from the financial meltdown of 2008, as well as the various permutations of the European sovereign debt crisis that have plagued the financial markets during the last two years or so. [Data are through the last update to the STLFSI, 12/9/11.]

Looking at some of the spikes in the chart, the first thing that strikes me is just how closely the two measures of risk have moved during the past five years. Also worth noting is the fact that both the VIX and the STLFSI indicate that the degree of risk/stress in the financial markets over the last few months has been slightly higher than what happened in one of the earlier Greek chapters of the euro zone debacle back in May and June of 2010.

More importantly perhaps, both the recent VIX and STLFSI data suggest that the current threats to the global financial markets are at least an order of magnitude lower than what we experienced in late 2008 and early 2009. This is not to say that both the VIX and STLFSI cannot spike much higher in short order, only that according to both measures, we now appear to be on the downhill side of the crisis.

For more information on the components of the STLFSI and the index’s long-term performance, check out St. Louis Fed’s Financial Stress Index.

Related posts:

• Zooming in on the St. Louis Fed’s Financial Stress Index
• St. Louis Fed’s Financial Stress Index
• Market Psych Offers Language-Based Fear Index
• Three Fear Indicators (or…The Three Baritones)
  VIX Showing Signs of Progressive Desensitization
• Availability Bias and Disaster Imprinting
• Chart of the Week: Record Low Yields for the 2-Year U.S. Treasury Note
• Chart of the Week: 10-Year Treasury Note Yield
• Chart of the Week: Ratio of VIX to Yield on 3 Month T-Bills
• The Credit Default Swap Canary
• A Sentiment Primer (Long)

[source: Federal Reserve Bank of St. Louis]

Disclosure(s): none

It seems well-nigh impossible for a December to pass without some sort of movements in the CBOE Market Volatility Index (the formal name of the VIX, for those who may have a short memory) that leave investors scratching their heads. In light of this, it appears I will be responsible for at least one December post reminding investors about the idiosyncrasies of implied volatility and the VIX during the holiday season.

There are a number of ways to look at the typical holiday swoon in the VIX, which I have labeled (the holiday effect or calendar reversion) for easy tagging and backtracking. From a strict fundamental perspective, the biggest change during the December/January holidays is fewer trading days, which means a shorter runway for stocks to depart for some unusual destinations. The other big factor is one of seasonality, specifically the tendency for December to be a bullish month for stocks.

I have chronicled how these factors influence the VIX and the strange prints they sometimes leave on the charts in posts from previous years (see links below.)

This year I am offering a chart which shows that in any given year, there is about a 40% chance that the VIX will make its annual low in December and as I discussed last year in VIX and the Week Before Christmas, the bottom usually comes in the last half of the month and most often just before Christmas.

In three trading sessions the VIX is already more than 20% off of its 30.91 close from last Thursday. It seems rather far-fetched to think that the VIX will plummet all the way below the current 2011 low reading of 14.27 from April 28^th of this year (a date that is provisionally included in the chart below,) but stranger things have happened.

Even if you think the European sovereign debt crisis will see several more eruptions before the end of the year, don’t be surprised if the VIX is sleeping with the fishes for the next week or two.

Related posts:

• VIX and the Week Before Christmas
• Chart of the Week: Historical Volatility Plummets in Seasonal Swoon
• VIX Holiday Crush
• Chart of the Week: VIX Support
• VIX Put Matrix Offers Glimpse of Expected Future
• The Incredible Shrinking VIX
• Where Will the VIX Bottom?
  

This week marks the first time that the front two months of the VIX futures term structure have been in backwardation each day for more than three consecutive months. In fact, the current streak of 68 days eclipses the old record of 63 days that dates to the 2008 financial crisis.

While the backwardation streak is intact for the front two months, when looking at the full VIX futures term structure, the futures curve has reverted to contango five times over the course of the past three weeks. The primary reason that the front two months have remained in backwardation in defiance of the rest of the VIX futures term structure has to do with something I call the “holiday effect” or “calendar reversion.” Essentially, what happened a little over two weeks ago was that the roll from the October front month to the November front month VIX futures, as well as from the November second month to the December second month VIX futures has added some incremental holiday effect backwardation to the front two months. This is due to the fact that the second month VIX futures have an expiration of December 21^st, and these are artificially depressed due to the historically low volatility associated with the holiday season. The impact is being felt by all the short-term VIX futures ETPs that are buying second month (December) VIX futures at artificially depressed levels and selling front month (November) VIX futures as part of the daily rebalancing process.

The graphic below shows the 1.70 point differential between the front month and second month VIX futures. Note that it is not until February 2012 that the term structure starts to flatten out, as investors begin to converge on the idea that the VIX is likely to hug the 30 level for the better part of the first half of next year.

Related posts:

• VIX Backwardation Commentary
• Capitulation in Back Month VIX Futures
• VIX Futures: What Were/Are They Thinking?
• More Volatility + Less Fear = Lower VIX?
• VIX Term Structure Changes Since November 20th
• VIX and the Week Before Christmas
• Short-Term and Long-Term Implications of the 30% VIX Spike

[source: Interactive Brokers]

Disclosure(s): short VIX at time of writing

If you think the last two weeks have turned the investing world upside down, well you have to look no farther than the VIX futures term structure to see just how accurate that view is. Two weeks ago the VIX was in the 17s and the VIX futures term structure was in contango (upward sloping) and today the VIX closed at 32 and the VIX futures term structure is in backwardation. In fact, the current VIX term structure looks a lot like a mirror image of what it was two weeks ago.

In the graphic below, I have detailed the shift in the term structure from July 22^nd to today’s close. During that period, the S&P 500 index has sold off 10.8%, while the VIX has spiked 82.6%. Note that the front month (August) VIX futures have advanced sharply – up 59% during this period – but not as sharply as the VIX. Looking at the back end of the term structure, the March 2012 futures were not traded back on July 22^nd, so the February futures are the most distant futures for which we can compare prices. Their move lagged the VIX and front month futures by a large margin and was almost identical in magnitude to that of the SPX, up 10.7% in those two weeks. One can clearly see from the funnel formed by the two term structure lines that for each month farther out in the term structure, the VIX futures were less responsive to the move in the SPX or the VIX.

In addition to annotating the backwardation and contango in the graphic, I have also circled the December VIX futures and options expiration (December 21^st) in an effort to preempt some questions about why these futures seem unusually low both now and two weeks ago. The simple answer is the preponderance of holidays toward the end of the year, with fewer trading days translating into fewer opportunities for extended moves in volatility. I have discussed this phenomenon many times in the past (see VIX and the Week Before Christmas, for starters) and have named it the “holiday effect” or “calendar reversion.” Also note that December has a history of being relatively bullish for stocks, with low volatility.

Finally, I have fielded quite a few questions about the implications of yesterday’s 35.4% VIX spike. Here some prior research on the Short-Term and Long-Term Implications of the 30% VIX Spike will undoubtedly be of interest to most readers. The quick takeaway is that this event is bullish for stocks and bearish for volatility. I would expect to see more evidence of this fact beginning to kick in on Monday.

Related posts:

• Capitulation in Back Month VIX Futures
• VIX Futures: What Were/Are They Thinking?
• More Volatility + Less Fear = Lower VIX?
• VIX Term Structure Changes Since November 20th
• VIX and the Week Before Christmas
• Short-Term and Long-Term Implications of the 30% VIX Spike
  

Since I haven’t seen it mentioned anywhere else, I thought I should note that 20-day historically volatility in the S&P 500 index hit its lowest level since April 1971, the same month that the Rolling Stones released Sticky Fingers and Charles Manson was sentenced to death.

Now there are multiple ways to calculate historical volatility. I outlined my preferred non-centered methodology in Calculating Centered and Non-Centered Historical Volatility, which yielded a 20-day HV of just 4.57 as of Friday’s close, barely 25% of the VIX’s closing value of 17.75 from the same day.

Of course, some of this disconnect is due to the holiday effect or calendar reversion, but given that we are seeing near-record lows in some volatility measures just two years and a couple of weeks removed from a VIX of 80+ should certainly raise some eyebrows.

In terms of implications going forward, today’s big(ger) move should herald the return of more normal volatility, as well as more middling implied and historical volatility measures.

Related posts:

• Calculating Centered and Non-Centered Historical Volatility
• What Is Historical Volatility?
• Thinking About Volatility (First in a Series)
• VIX and the Week Before Christmas
• Chart of the Week: Historical Volatility Plummets in Seasonal Swoon

I guess I should not be surprised that a VIX of 15.45 – the lowest since July 2007 – has all manner of pundits scrambling to pull some sort of explanation out of a hat and weave it into their favorite bullish or bearish forecast for the markets.

In fact, the new low in the VIX is not a big deal, at least during this time of the year. I have talked about this before on a number of occasions, including in VIX Holiday Crush and earlier this week in Chart of the Week: Historical Volatility Plummets in Seasonal Swoon. Call it the holiday effect or calendar reversion, but when the VIX’s 30-day window includes two holidays and two additional historically slow days in advance of the Christmas and New Year’s holidays, volatility has a tendency to take a vacation.

How strong is the tendency toward a low VIX? Well, consider that in five of the last eight years, the annual low in the VIX fell during the week leading up to Christmas. Last year, some may recall that the VIX made its annual low on Christmas Eve. Back in 2004, the VIX had its low for the year on December 23^rd; and in both 2003 and 2006, the VIX bottomed out for the year on December 18^th. Today’s low makes it five pre-Christmas bottoms in eight years.

So keep a close eye on the VIX and feel free to marvel at how low it goes, but consider that during the holiday season, experienced investors will give very little credence to the absolute level of expected 30-day implied volatility in S&P 500 options. Only after the first of the year should we take the VIX numbers seriously, regardless of how low prices and implied volatility levels may be marked down in the pre-Christmas shopping rush.

Related posts:

• Chart of the Week: Historical Volatility Plummets in Seasonal Swoon
• VIX Holiday Crush
• Chart of the Week: VIX Support
• VIX Put Matrix Offers Glimpse of Expected Future
• Where Will the VIX Bottom?

‘Tis the season for the annual holiday effect in which historical volatility (HV) has a strong tendency to plunge and drag implied volatility down with it. This is a subject I have tackled on a number of occasions in the past (see links below) and is really just a longer variant of what I call calendar reversion – the tendency of the VIX to fall an extra 1% or so on Fridays due to market makers adjusting prices ahead of the weekend. The lack of volatility all boils down to the same root cause: fewer trading days during the 30 calendar day window specified by the VIX (and implied volatility in general) means there are fewer opportunity for stocks to stray significantly from the path projected by efficient markets, standard deviations and the rest of the normalcy regime.

As of Friday’s close the S&P 500 index had a 10-day historical volatility of 5.5, which is the lowest reading since May 2007. In this week’s chart of the week below, I have elected to show the 10-day historical volatility of the Russell 2000 small cap index (RUT), which traditionally has higher volatility than the SPX and is also more susceptible to the winds of economic change and uncertainty. As the chart shows, 10-day historical volatility (white line) sits at a two-year low and has helped to pull the implied volatility (red line) of the index down below 20. Note that last week the CBOE Russell 2000 Volatility Index (RVX) dipped as low as 19.55 and is threatening to drop below the 19.00 level for the first time since June 2007.

After the first of the year I expect to see the holiday effect magically disappear and HV, IV and volatility indices begin to reflect a more accurate view of investor expectations.

Related posts:

• SPX Historical Volatility at Two Year Low
• Historical Volatility and Seasonality Push VIX Below 20
• Historical Volatility Pointing to a Sub-20 VIX
• VIX Holiday Crush
• Sideways Markets, Covered Calls and the RUT
  

While it is widely understood that the VIX has a tendency to fall during the holidays (due largely to fewer trading days), a point that slipped past many pundits is that historical volatility (HV) has been excessively low during the past few weeks. In fact, last Wednesday the 20 day historical volatility in the SPX slipped below 10.00 for the first time since October 2007, about one week after the SPX topped at 1576.

Historical volatility in the SPX did rise a little to end 2009 at 10.23, but even at that level, HV sits at the 17^th percentile of SPX 20 day historical volatility readings for the past decade.

For the record, low HV20 readings pushed the ratio of the VIX to SPX HV20 to 2.12 on Friday – a level has only been reached four times in the last decade. Of those four instances, three (January 2000, January 2002 and May 2007) occurred prior to a substantial selloff.

The chart below shows the recent divergence between 30 day implied volatility (red line) in the SPX and 20 day historically volatility (blue line). More often than not, when IV is substantially higher than HV, this is a bearish signal – or at least an indication that it is a good time to take profits.

For more on related subjects, readers are encouraged to check out:

• Historical Volatility and Seasonality Push VIX Below 20
• Historical Volatility Pointing to a Sub-20 VIX
• VIX Holiday Crush

[source: Livevol Pro]

Disclosure: Livevol is an advertiser on VIX and More

The CBOE Volatility Index (VIX) slipped below 20.00 for the first time since August 2008, ultimately closing at a 16 month low of 19.54 today.

When I called for a sub-20 VIX last Wednesday in Historical Volatility Pointing to a Sub-20 VIX, the crux of my argument was that “if HV [historical volatility] continues to fall, the case for a 20+ VIX will deteriorate rapidly. Substantial divergences tend to have a relatively short life. With the current divergence now at six trading days, the VIX can only defy gravity for a short while longer.” I further noted seasonal factors (such as the holiday effect) at work and was also emboldened in my prediction by what I call calendar reversion – the tendency of the VIX to fall an extra 1% or so on Fridays due to market makers adjusting prices ahead of the weekend to compensate for the mismatch between the five day trading week and the seven day calendar week.

Now that the VIX has closed below 20, however, there is no reason to assume it will not go lower. Even without accounting for seasonal factors, which include a 3 ½ day trading week this week followed by a 4 day trading week next week, current historical volatility data suggest a fair value for the VIX in the mid-17s.

While I think we have a while to go before investors are comfortable with a VIX that is more than a point or two away from the 20s, today should go a long way toward muting the cry that a VIX of 20 is sufficiently low to necessitate a selloff in stocks.

For more on related subjects, readers are encouraged to check out:

• Historical Volatility Pointing to a Sub-20 VIX
• VIX Holiday Crush
• VIX of 20 Spurring Market Correction?
• What Is Historical Volatility?

[source: StockCharts]

Disclosure: none

Just as I get in an extended discussion of historical volatility (HV), I note that the combination of 10/20/30/50/100 day HV has plummeted to levels not seen since mid-October 2007, which happens to be one week after the all-time high in the S&P 500 index.

It is worth noting that back in mid-October 2007 when the similar HV numbers were posted, the VIX was hovering around the 18.00 level.

With the VIX Holiday Crush starting to kick in and the drama associated with today’s FOMC meeting now behind us, I now believe there is about a 50% chance that the VIX dips below 20 in the next two days, even with the E-mini S&P 500 futures (/ES) down 4.50 as I type this. The alternative, which has been the status quo as of late, is that the 20 area acts as support for the VIX and triggers resistance in stocks.

Now the VIX does not have to follow historical volatility religiously, but if HV continues to fall, the case for a 20+ VIX will deteriorate rapidly. Substantial divergences tend to have a relatively short life. With the current divergence now at six trading days, the VIX can only defy gravity for a short while longer…

For more on related subjects, readers are encouraged to check out:

• VIX Holiday Crush
• VIX of 20 Spurring Market Correction?
• What Is Historical Volatility?
• Calculating Centered and Non-centered Historical Volatility
• Thinking About Volatility (First in a Series)

Disclosure: none

As the chart below shows, the last two times the VIX has taken a run at 20 (late October and late November), stocks have responded by selling off and spiking volatility. It is possible that a VIX of 20 may still be something that investors are not yet ready to accept (availability bias), but with historical volatility hovering around 16 and the long-term trend in the VIX still moving downward, it is likely just a matter of time before we see a VIX in the 19s.

In addition to the absolute levels of the VIX, one must always watch relative VIX levels, which is where the moving average envelopes come in. Displayed as a blue zone in the middle of the trading range on the chart, the 10 day simple moving average envelopes make it easy to identify when the VIX is extended to the high side or the low side. While the 20 level has been well out of the moving average envelopes for the last two drops in the VIX, that is not likely to be the case going forward. This sets the possibility of a battle between the absolute VIX (support at 20) vs. the relative VIX (support at the bottom of the envelope) in the near future, with an increased likelihood that the 20 level does not hold the next time around.

Finally, it is that time of year where I feel compelled to remind everyone that seasonal factors also indicate that volatility should be moving lower. I have discussed the holiday effect several times in the past in this space and essentially the historical pattern calls for the VIX to hold relatively steady for the first two weeks of December, then drop sharply (probably about 1.5 points at current levels) as Christmas approaches.

For more on these subjects, readers are encouraged to check out:

• VIX Holiday Crush
• Charting the VIX with 10 Day SMA Envelopes
• VIX Kitchen Sink Chart

[source: StockCharts]

Disclosure: none

There are quite a few ways in which to measure historical volatility. Probably the most responsive of the time periods commonly measured is the 10 day historical volatility (HV) period, which covers the last 10 trading days. Variously referred to as statistical volatility, realized volatility, actual volatility, etc., the 10 day historical volatility measure for the SPX (dotted blue line in chart below) peaked on October 22^nd at just a fraction under the 100 level. On December 3^rd the 10 day HV was still holding strong at 89, but it has fallen precipitously over the course of the last three weeks and is down to just 35 as of Wednesday’s close and on target to dip as low as 33 or so today.

For comparison purposes, the 10 day HV in the SPX has not been below 35 since September 12^th, just prior to the Lehman bankruptcy.

The bottom line: while a VIX in the low 40s may look cheap at the moment, consider that the recent historical volatility in the SPX has been slightly more than three quarters of that represented by the VIX. Of course, the December holiday effect has artificially depressed volatility to some extent, but certainly cannot claim full responsibility for the drop in 10 day HV from 89 to 35.

[source: VIX and More]

The VIX has been steadily declining during the month of December, from the high 60s on the first day of the month to the neighborhood of 42 as I write this.

Clearly the extraordinary measures taken by the government to pump liquidity into the system have been responsible for some of the shrinking volatility, but since I often talk about the holiday effect on volatility and frequently receive questions on the subject, I thought it would be a good day to share some of my research on the subject.

Since 1990, the month of December has averaged 21.05 trading days. The chart below captures each of those 21 trading days from 1990-2007 in composite form, with the mean for all December VIX values set at 100. In the chart, the pattern of decreasing volatility is most evident from the middle of the month to just before Christmas, during which period volatility drops from 2.4% above the December average (10^th trading day) to 4.8% below the December average (17^th trading day).

For the record, today is the 17^th trading day of December, which makes the the historical low point in volatility for December.

I will not go so far as to say the that calendar suggests today is likely to be the last time the VIX dips under 42 for awhile, but those with an interest in historical context may wish to prepare for an increase in volatility, as the holiday ‘calendar reversion’ effect wears off.

[source: VIX and More]

In the blogosphere it’s hard to really say what ‘afar’ is – or even if there is such a thing – but I wanted to use this space to highlight three VIX-related posts that have recently caught my attention.

Earlier this morning, Macro Man (whose intellectual domain spans well beyond the macro) was ruminating on what a convergence of thinking about the VIX, the credit markets, and the US consumer might mean in terms of the future direction of the markets in a post aptly titled Fear and Greed. For the record, I have commented on the correlation between the SPX and the VIX on a number of occasions and have pointed out that a high positive correlation is more likely to foretell a bearish move than a high negative correlation.

Adam at Daily Options Report (as much as he posts, when does he have time to trade?) anticipated some of this yesterday in VIX Going Forward, in which he discusses the Holiday Effect and the tendency of traders to lower bids in order to better match the short trading week to the seven day calendar week used to price options. His Holiday Effect forecast: “volatility numbers on the board this week may be misleadingly low.” Bingo!

Getting a little farther afield, over the weekend, Brett Steenbarger at TraderFeed posted some very interesting research and analysis in Herding Behavior in the Stock Market: A Look at Volume Concentration. Frankly, this may be the most interesting stock market post I have read all year; rather than attempt to summarize his thinking, I am going to recommend that you click over and read his post in the original, as well as a related subsequent post, Herding Sentiment in the Stock Market and Prospective Index Returns. In between turkey (ham?) sandwiches, I will certainly be thinking about market sentiment, volatility, and herding over the next few days.

Happy holidays to all.