WHAT VIX, /VX, AND VIX RELATIVE TO /VX TELLS AND DOESN'T TELL US
I frequently look at VIX pricing relative to /VX futures front month pricing to determine whether "local volatility" (i.e., volatility on time frames less than /VX futures back months) is "overpriced." So, what do VIX, /VX futures, and VIX pricing relative to the futures tell us?
VIX was 16.19 at Friday market close vs. /VX Nov futures priced at 16.64; Dec at 17.09. vixcentral.com/ In other words, we're still in a state of contango since the front month expiries in the futures are more expensive relative to the VIX "spot price." Conversely, you can look at "spot" versus front month futures from the perspective that the back month futures are "overpriced" relative to the current spot price or that market is currently pricing in a volatility expansion going forward.
However, if you look at VIX spot relative to /VX futures pricing on a regular basis, you'll know that this is largely "the ordinary state of affairs" -- that the front month is virtually always "pricier" than spot and that the market is virtually always apparently pricing in a potential volatility expansion going forward. I say "apparently" because this "structure" does not mean that the market is anticipating a downturn; rather, the upward curve of /VX futures pricing merely reflects a purchase of protection against a potential market downturn, the statistical likelihood of which increases over time (i.e., the likelihood of a VIX pop to >20 is simply statistically greater over a six-month time frame than a one-month one). Looked at from this perspective, the curve of /VX futures pricing is not really an indicator of future market movement; it's merely an acknowledgement that the statistical risk of an occurrence of a significant dip increases over time.
In comparison to the /VX curve, the trajectory of VIX "spot" pricing, standing alone, can be looked at as a shorter-term sentiment indicator that is reflective of purely subjective, perceived risk of a short-term market down turn given circumstances that evolve on a day-to-day basis. It does not mean that the market is going to go the way that VIX pricing suggests; it merely means that bets are being placed on one side of the equation (usually reflected by call side buying) "just in case." Contrary to how some traders view VIX/VIX derivative movement (that it portends future market direction), a "just in case" trade is not a directional bet that the market will go a certain way; it's just a purchase of protection in the event it does.*
In any event (and regardless of whether you agree or not with what VIX spot is telling you with respect to market direction going forward), things get interesting when front month VIX spot price is greater than back month futures prices, implying either that spot price is overvalued relative to the futures or that the market is anticipating a likely contraction of volatility going forward. This "backwardation" briefly occurred on Friday, with VIX trading higher relative to where Nov /VX futures which were trading -- to me, a signal to sell premium.
As usual, this state of affairs didn't last long ... . VIX ended the day lower relative to the Nov future.
* -- 2016 provides at least one example of how VIX/VIX derivative call buying can be an incredibly incorrect indicator of market direction. A large number of traders bought VIX/VIX derivative "just in case" call side protection in anticipation of a June rate hike that never materialized; the vast majority of those calls expired worthless.
VIX was 16.19 at Friday market close vs. /VX Nov futures priced at 16.64; Dec at 17.09. vixcentral.com/ In other words, we're still in a state of contango since the front month expiries in the futures are more expensive relative to the VIX "spot price." Conversely, you can look at "spot" versus front month futures from the perspective that the back month futures are "overpriced" relative to the current spot price or that market is currently pricing in a volatility expansion going forward.
However, if you look at VIX spot relative to /VX futures pricing on a regular basis, you'll know that this is largely "the ordinary state of affairs" -- that the front month is virtually always "pricier" than spot and that the market is virtually always apparently pricing in a potential volatility expansion going forward. I say "apparently" because this "structure" does not mean that the market is anticipating a downturn; rather, the upward curve of /VX futures pricing merely reflects a purchase of protection against a potential market downturn, the statistical likelihood of which increases over time (i.e., the likelihood of a VIX pop to >20 is simply statistically greater over a six-month time frame than a one-month one). Looked at from this perspective, the curve of /VX futures pricing is not really an indicator of future market movement; it's merely an acknowledgement that the statistical risk of an occurrence of a significant dip increases over time.
In comparison to the /VX curve, the trajectory of VIX "spot" pricing, standing alone, can be looked at as a shorter-term sentiment indicator that is reflective of purely subjective, perceived risk of a short-term market down turn given circumstances that evolve on a day-to-day basis. It does not mean that the market is going to go the way that VIX pricing suggests; it merely means that bets are being placed on one side of the equation (usually reflected by call side buying) "just in case." Contrary to how some traders view VIX/VIX derivative movement (that it portends future market direction), a "just in case" trade is not a directional bet that the market will go a certain way; it's just a purchase of protection in the event it does.*
In any event (and regardless of whether you agree or not with what VIX spot is telling you with respect to market direction going forward), things get interesting when front month VIX spot price is greater than back month futures prices, implying either that spot price is overvalued relative to the futures or that the market is anticipating a likely contraction of volatility going forward. This "backwardation" briefly occurred on Friday, with VIX trading higher relative to where Nov /VX futures which were trading -- to me, a signal to sell premium.
As usual, this state of affairs didn't last long ... . VIX ended the day lower relative to the Nov future.
* -- 2016 provides at least one example of how VIX/VIX derivative call buying can be an incredibly incorrect indicator of market direction. A large number of traders bought VIX/VIX derivative "just in case" call side protection in anticipation of a June rate hike that never materialized; the vast majority of those calls expired worthless.
Comment:
Me personally, I use VIX for one thing and one thing only -- as an indicator of broad market implied volatility and as a signal, therefore, to sell premium in broad market instruments.