Update on VIX /VXV - Volatility contango intact but muted.

Volatility traders over the last weeks have been seeing a "flattening" of volatility structure and have not been getting the returns they were expecting for contango trades. (If you want to see contango at work, pull up a 5 year chart of UVXY             . Those losses? Contango.)

These charts show what is happening. The VIX             (short term volatility) is rising from its depressed levels in late May while VXV             (90 day volatility) is rising at a slower rate from a deeper fall in May. Why is that important? Remember that all of these volatility ETNs / ETFs have "roll." Roll is the daily sale of short term volatility and purchase of mid term volatility. Where do they get their supply of short term volatility to sell? From holding the mid term until it becomes short term. Just about any volatility symbol you can buy or sell employs such a strategy.

So how does that create a flattened volatility structure? Simple. On some days that the VIX             spikes a bit, those short term volatility sales (purchased as mid term contracts weeks before, when the VXV             was depressed too) are actually profitable. Normally there is loss due to theta and risk premium. But all futures players know that the key to winning is entering and exiting at a price move before theta and premium gets you. Well these ETFs are doing that on a few days here and there by pure luck. Most days theta and risk premium produce the deep contango that vol             traders love. Do the math - as the VIX             slowly rises so will the VXV             , but if the VIX             leads (which it is doing now) then there will be more days where those purchased-as-mid-term-and-sold-as-short-term vol             contracts pay. Certainly not every day - just some days.

The structure is flattening also in part due to the volume of trades these ETFs / ETNs (and the array of HFT             systems that arbitrage them and their underlying trades) generate. There is a "tail wagging the dog" effect that this volume has created that didn't exist when vol             futures were only affected by OTM Put bidding on the S&P             . More and more trades bypass OTM Puts and go straight to volatility. The VIX             itself doesn't "see" those trades (partly why it is historically low and is likely to stay low.)

The VIX/VXV ratio chart on the left shows us this "flattening" as we touch that magic .9 threshold that induces backwardation fear. I placed an indicator underneath it that shows the contango rate movement of one of the highest volume vol             ETNs out there - my fav of favs, UVXY             . The orange line is the daily contango rate. A spike above 1 generally means the contracts rolled that day were at a profit and below at a loss. The white and black lines are smoothing functions. Notice the black line rising slightly but still under 1? That means one thing: Volatility contango is intact but muted.

The VIX             will bounce around day to day and should continue rising such that we see spikes into 17s once in a while again. So there will be more days where the roll is a winner. But over all it remains a loser. Just look again at that 5 year UVXY             chart.
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