EuroCurrency Volatility Index (EVZ) at Lowest Level Since March 2008, Diverges from VIX

Since its launch in August 2008, the CBOE EuroCurrency Volatility Index (ticker EVZ, sometimes known simply as the “euro VIX”), which is based on the FXE ETF, has toiled in relative obscurity compared to some of the more famous volatility indices.

Given all the fears about the European sovereign debt crisis over the past few years, I find the lack of interest in EVZ to be surprising. After all, in thinking about the euro zone one of the most basic questions has been whether or not the euro will survive.  Further, outside of the U.S. at least, the future of the euro zone is still considered to be the biggest risk to the stock market.

With all this in mind, I was looking at EVZ data this evening and discovered that today marks five years since the beginning of the historical EVZ data provided by the CBOE (reconstructed data fills the gap from November 2007 to the August 2008 launch.)

The chart below shows the history of closes in EVZ (blue line), as well as comparative closing prices for the VIX (red line.) I have annotated the chart to highlight two pieces of information:

1. The last time that EVZ closed lower that it did today (8.55) was in March 2008, just before Bear Stearns collapsed and was sold to JP Morgan (JPM)
   
2. The recent divergence between a falling EVZ and a rising VIX, which dates from the middle of September, is unusual, particularly given the length of the divergence

So…is EVZ understating the risk to the euro or is the VIX overstating the risk to stocks? Is it possible that these two measures of risk can be moving in opposite directions and both be right?

Related posts:

• U.S Fiscal Cliff Fears Top VIX Fear Poll Again
• U.S. Fiscal Cliff Concerns Top Results in Inaugural VIX and More Fear Poll
• The Evolution of European Equity Risk
• Euro Volatility and Risk
• Greek Elections and the Future of the Euro
• Handicapping the Chances of Greece Dropping the Euro
• The Evolution of the Volatility Index Family Tree
• A Conceptual Framework for Volatility Events
• Forces Acting on the VIX
• Thinking About Volatility (First in a Series)

[source(s): CBOE]

Disclosure(s): none

U.S. Fiscal Cliff Fears Top VIX and More Fear Poll Again

For the second week in a row, investors cited the U.S. fiscal cliff as the top risk to the stock market, followed closely by fears about the European sovereign debt crisis. Concerns about weak earnings, a distant third last week, gained significant ground as Apple (AAPL) and others continued to report disappointing earnings and revenues while guiding future expectations lower.

As was the case last week, geography appears to have a significant influence on results, with a clear Americentric bias coming from U.S.-based respondents. In the U.S., for instance, concerns about the fiscal cliff outpolled the European sovereign debt crisis by 9.5%, but outside of the U.S. the European sovereign debt crisis topped concerns about the fiscal cliff by 8.2%. Similarly, 15.2% of U.S. respondents cited U.S. election uncertainty as the biggest risk to stocks while just 5.5% of non-U.S. respondents judged U.S. elections to be the top risk factor.

This week I added inflation and deflation to the list of pre-populated answers. Both responses fell far down the list of concerns, but almost twice as many respondents expressed concern about inflation relative to deflation.  While the graphic below shows the week-to-week changes in the top four issues driving stock market fears, it will probably be several more weeks before this graphic offers meaningful insights.

Once again, there were quite a few write-in votes, but there was no discernible theme among write-in responses.

With U.S. stock markets closed today due to hurricane Sandy, the VIX currently stands at 17.81, some 7.2% higher than it was a week ago when I published the results of the inaugural VIX and More Fear Poll.

Related posts:

• U.S. Fiscal Cliff Concerns Top Results in Inaugural VIX and More Fear Poll
• Expectations, Surprises and Fear in 2011
• A Conceptual Framework for Volatility Events
• Forces Acting on the VIX
• Fukushima Daiichi and ‘Event Theta’
• Thinking About Volatility (First in a Series)
• How to Trade Options Around Volatile Events (Barron’s)
• Be Greedy While Others Are Fearful (Barron’s)

Disclosure(s): long VIX and short AAPL at time of writing

U.S. Fiscal Cliff Concerns Top Results in Inaugural VIX and More Fear Poll

Today I closed the books on the first VIX and More Fear Poll, which I consider to be an unqualified success and a first step in establishing longitudinal data about the types of geopolitical, macroeconomic, technical and other issues that make investors fearful, anxious and uncertain about the future of the stock market.

In a battle that went down to the wire, 28.7% investors voted the U.S. fiscal cliff as their #1 concern right now, followed closely by fears about the European sovereign debt crisis, which 27.1% labeled as their top issue. The prospect of a weak earnings season was a distant third at 13.1%.

[source(s): VIX and More]

There were some interesting findings when the 244 responses were broken out geographically. In the U.S., for instance, the fiscal cliff issue dominated the European sovereign debt crisis, 31.5% to 22.2%, with weak earnings third at 15.4%. Looking at non-U.S. responses, the Americentric bias disappears, as 36.6% of respondents tab the European sovereign debt crisis as their top worry, followed by the fiscal cliff (23.2%) and U.S. elections (9.8%).

While there were quite a few write-in votes, no theme emerged from these responses, though central bank interventions, U.S. debt, deleveraging, higher interest rates, high-frequency trading, demographics and technical factors were among the issues cited.

Among some of the questions raised by the results are the role of local and national media in shaping investors’ fears and the tendency of investors to overemphasize events that are closest to home. These are just two of the issues that I hope to explore going forward, making use of some of the data generated by this poll over time and comparing the ebb and flow of concerns against the ebb and flow of the VIX.

Going forward, I anticipate a weekly VIX and More Fear Poll each weekend, with the results and some takeaways to be published at about the same time every week.

Related posts:

• The Evolution of European Equity Risk
• Euro Volatility and Risk
• Chart of the Week: As Goes Spain...
• Chart of the Week: VSTOXX, VIX and the Risk of Global Contagion
• Expectations, Surprises and Fear in 2011
• Availability Bias and Disaster Imprinting
• VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis
• A Conceptual Framework for Volatility Events
• Forces Acting on the VIX
• Fukushima Daiichi and ‘Event Theta’
• Thinking About Volatility (First in a Series)
• How to Trade Options Around Volatile Events (Barron’s)
• Be Greedy While Others Are Fearful (Barron’s)

Disclosure(s): none

The 2012 VIX Futures Term Structure as an Outlier

Investors who have been trading the VIX futures, VIX options and VIX exchange-traded products in 2012 have no doubt observed that there has been a wide gulf between the volatility predicted by the VIX front month futures and the back month futures. How wide? Well the graphic below shows the average (mean) normalized term structure for each year since the VIX futures were launched, back in 2004. In normalizing the data, I have set the average front month VIX futures contract to 100 and have expressed the averages of the second through seven months as multiples of the front month.

[Note that while the VIX futures were launched in 2004, consecutive VIX futures contracts for the first six months were not available until October 2006, hence the dotted lines for these years to reflect the erratic nature of the data. Also, I have included the seventh month contract in the calculations because this month is critical to the calculations of a number of VIX ETPs, including VXZ, VIXM, ZIV, etc.]

[source(s): CBOE]

For anyone who has followed the VIX futures closely, it should come as no surprise that 2008 (solid red line) is the only year in which the full VIX futures term structure was in backwardation (front months higher than back months) in aggregate. During 2009 (solid orange line), the term structure transitioned from backwardation to contango (front months higher than back months) and for the most of the balance of its life, the VIX futures term structure has remained in contango.

The graphic shows no discernible trend of extreme contango evolving over the past few years. While 2010 is the year with the second highest degree of contango across the full term structure, contango was decidedly muted during 2011. In fact, 2011 saw the longest continuous stretch of backwardation during the height of the European sovereign debt crisis.

Looking closely at the differences between 2012 and 2010, there is very little difference in contango out to the second month. The normalized term structure curves begin to diverge substantially only after the third month, where the 2010 term structure begins to flatten and the 2012 term structure continues an almost linear ascent. In fact the most distinctive feature of the 2012 term structure is the absence of any significant flattening in the VIX futures curve in months four, five, six and seven. This is part of the reason that while XIV is up 165% for the year, ZIV has managed a gain of 72%.

As this series continues, I will examine some of the possible causes of the recent persistent steep contango in the VIX futures term structure, particularly in some of the back months.

Posts in current series on VIX futures:

• Violent Disagreement Across VIX Futures
• Ratio of VIX to Realized Volatility Higher Than Any Year Since 1996

Related posts:

• Crazy VIX:VXV Ratio Chart
• Tracking the Fall in VIX Futures
• Third Steepest First-Second Month VIX Futures Contango Ever
• Monitoring VIX Futures and Their Impact on VIX ETPs
• ZIV Undeservedly Neglected
• VIX Exchange-Traded Products: The Year in Review, 2011
• VXX Calculations, VIX Futures and Time Decay
• Availability Bias and Disaster Imprinting
• VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis
• Thinking About Volatility (First in a Series)

Disclosure(s): long XIV and ZIV at time of writing

Ratio of VIX to Realized Volatility Higher Than Any Year Since 1996

Before I dive into a series of posts about the VIX futures, I think it is important to add some context in the form of several observations about the relationship between the VIX and the historical volatility (HV) of the S&P 500 index. In the absence of any information about the future, it turns out that historical volatility (a.k.a. realized volatility or statistical volatility) can provide a reasonably accurate measure of future volatility. In fact, it is more difficult than one might imagine to incorporate information about the future to come up with a better estimate of future volatility than what can be gleaned just by extrapolating from recent realized volatility.

Looking at historical data, the VIX has an established history of overestimating future realized volatility. In fact, in the 23 years of VIX historical data, there was only one year – 2008 – in which realized volatility turned out to be higher than that which was predicted by the VIX.

As the chart below shows, early traders made a habit of dramatically overestimating future volatility. From 1990-1996, for instance, the VIX overshot realized volatility by an average of 49%. Since 1997, the magnitude of that overshoot has dropped dramatically, to about 24%, as investors apparently began to realize that they had been overpaying for portfolio protection in particular and for options in general.

[source(s): CBOE, Yahoo]

That being said, 2012 has been an unusual instance in which the VIX has overestimated 10-day historical volatility in the SPX by 47% – the biggest cushion since 1996. Not surprisingly, low realized volatility tends to depress the VIX and the front end of the VIX futures term structure in general. For that reason, the unusually low average 10-day historical volatility of 12.25 experienced so far in 2012 can serve as a partial explanation for the steepness of the VIX futures term structure (extreme contango) yet given the history of even lower volatility numbers during 2004-2007, the low historical volatility for 2012 is at best a very small portion of the full explanation. Two better potential explanations for the steep VIX futures term structure are the psychology of the 2008 financial crisis and its aftermath (i.e., disaster imprinting, availability bias, the recency effect, etc.) and expectations of future higher volatility due to a geopolitical and macroeconomic overhang that has generated a much higher level of anxiety about future prospects than in more uneventful economic times. Then, of course, there is the issue of the role of mushrooming growth in VIX exchange-traded products as an influence on the VIX futures term structure.

Before I address those issues in more detail, however, the next installment in this series is a discussion of the evolution of the VIX futures term structure.

Related posts:

• VIX Premium to Historical Volatility at Record High in Q1
• S&P 500 Index 20-Day Historical Volatility Hits 39-Year Low
• VIX and Historical Volatility Settling Back into Normal Range
• Chart of the Week: No More Free Lunch for Volatility Sellers?
• The Gap Between the VIX and Realized Volatility
• What Is Historical Volatility?
• Rule of 16 and VIX of 40
• Availability Bias and Disaster Imprinting
• VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis
• Calculating Centered and Non-Centered Historical Volatility
• Thinking About Volatility (First in a Series)

Disclosure(s): none

Violent Disagreement Across VIX Futures

Something strange has happened to the VIX futures in 2012: for the first time in their history, the VIX futures persist in being in violent disagreement with each other. Prior to 2012, for instance, the average difference between the front month and seventh month VIX futures was about 16%. This year that number has surged to more than 38%.

The VIX futures term structure has been in extreme contango (back months higher than front months) for the better part of 2012, with 17 days in which the contango across the full VIX futures curve has exceeded the all-time record that stood prior to 2012. It is almost as if the idea of a flat VIX futures term structure curve is passé and traders are convinced that the short-term volatility picture is perpetually an aberration that bears little resemblance to longer-term volatility expectations. Can these two differing perspectives of the future of volatility meaningfully coexist? If not, which view is likely to be wrong?

In a series of upcoming posts, I will put the issue of a VIX futures term structure in disarray under the microscope and discuss issues such as the huge gap between implied volatility and realized volatility, disaster imprinting and the role of the recent financial crisis in shaping future volatility expectations, looming issues such as the European sovereign debt crisis, the fiscal cliff, the potential for a hard landing in China, etc.

Ultimately I will attempt to answer the question of whether the back month VIX futures should be trading at levels that are 45-90% higher than the front month VIX futures, as has been the case for the past two months. I will also look at some of the implications for trading VIX futures, VIX options and VIX exchange-traded products.

In the interim, some of the links below might provide some useful background and context.

Related posts:

• Crazy VIX:VXV Ratio Chart
• Tracking the Fall in VIX Futures
• Third Steepest First-Second Month VIX Futures Contango Ever
• Monitoring VIX Futures and Their Impact on VIX ETPs
• ZIV Undeservedly Neglected
• VIX Exchange-Traded Products: The Year in Review, 2011
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• VIX Futures Brokers
• Availability Bias and Disaster Imprinting
• VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis
• Be Greedy When Others Are Fearful (Barron’s)

Disclosure(s): none

EVALS and the Stock of the Week Continue to Post Impressive Numbers

Lately I have been fielding quite a few questions about the VIX and More Subscriber Newsletter, and particularly about VIX and More EVALS, which is a model portfolio dedicated to trading VIX and volatility-centric exchange-traded products.

Rather than get into too many details in this space, I have elected to elaborate a little about each service on their respective blogs. For the newsletter, today I posted Q3 2012 Newsletter Update, with Stock of the Week +107% YTD and +4473% Since Inception, in which I provide some details about how I select the Stock of the Week, discuss some recent picks, and provide performance data going back to the March 2008 inception. As far as EVALS is concerned, this service has gone through two iterations, with the most recent iteration dating from November 2011 and focusing on VIX ETPs. In EVALS Q3 2012 Update: Up 70.59% Since November 2011 Inception I delve into some details about this model portfolio and provide a fair amount of data with respect to trades and performance.

For the record, I still generate content on a regular basis even when blog may appear to be dormant, as has been the case lately. While my personal trading is my first priority, content priority always goes to subscriber-based content such as the newsletter (published every Wednesday), EVALS, and Expiring Monthly magazine, where my contributions for the September issue included The FOMC 3 + 3 Trade as well as Trade Example: The September 2012 3 + 3.

For anyone who may be confused about how to differentiate between what I am writing about in various publications and locations, a good graphical reference can be found in Highlighting Newsletter Content Focus with Content Pyramid. I have also included pointers to a summary of my Expiring Monthly articles and Barron’s columns in the links below.

Last but not least, it appears my longer-than-expected hiatus on the VIX and More blog is now over and I can get back to posting free content on a regular basis. I also realize there are quite a few emails and blog comments which I need to attend to; I hope to address these in short order.

 

Related posts:

• Q3 2012 Newsletter Update, with Stock of the Week +107% YTD and +4473% Since Inception
• Changes to Newsletter Place More Emphasis on VIX Exchange-Traded Products
• Highlighting Newsletter Content Focus with Content Pyramid
• Newsletter and Portfolio Performance Update Through 12/31/10 (includes a discussion of the Stock of the Week)
• EVALS Q3 2012 Update: Up 70.59% Since November 2011 Inception
• EVALS Relaunches, Now Focusing on VIX Exchange-Traded Products
• Recent Research Projects and Expiring Monthly
• Guest Columnist at Barron’s: How to Trade Options Around Volatile Events

Disclosure(s): none

Updating the Legacy of Post-2009 Corrections

Of all the periodic themes that I update in this space, the one that always surprises me by how strong of a reception it generates is a table that I call the VIX and More 2009-12 SPX Peak to Trough Pullback Summary – of which a current version is appended below.

The table is a chronology of sorts of all the significant pullbacks since the March 2009 bottom in stocks. I have tweaked the definition of pullback a little so that it only includes pullbacks from new highs. For that reason, there are no significant pullbacks since the SPX made a new high for the year back on September 6^th. That being said, I am including the price action of the last two days as a provisional entry in red at the bottom of the table, with data as of one quarter of an hour to go in the trading day. Generally it takes a pullback of at least 2.5% - 3.0% to warrant inclusion in this table.

I suspect that the main reason investors enjoy this table is that it gives them some historical context for how the markets have recently been pulling back and thus helps to set expectations about how far the current or subsequent correction may extend. Prior to the current mini-pullback, the median pullback was 5.6%, while the mean pullback stood at 7.4%, thanks to several sharper corrections. Applied to Friday’s high of SPX 1474, these translate to a pullback to SPX 1392 or SPX 1365, respectively. Of course, this is where the “past performance is no guarantee of future results” type of disclaimer should be inserted, but historical parameters can help to set expectations.

Factoring in the Draghi and Bernanke puts, as well as the probability and magnitude of a hard landing in China, a reversal of fortune in the euro zone, a worsening of the fiscal cliff problem, flare-ups in various geopolitical hotspots, etc. may make predicting the current direction of the market even more difficult and perilous than usual.

That being said, given the 210 point rise in the SPX in a little over three months, investors cannot be faulted for exhibiting more than the usual amount of caution during the remainder of the year.

[As an aside, I love the way pundits talk about a correction, as if to imply that the market has been wrong about a recent bullish move and it is time for cooler heads and more reasonable valuations to have their way. Certainly there is no reason why there cannot be these same type of “corrections” when markets become oversold, but good luck finding those who talk about stocks correcting upward.]

Related posts:

• A Look at the Pullbacks of the 2009-2012 Bull Market
• What If Stocks Decline?
• A VIX Risk Reversal
• Why Not Point Hedges?
• The Case for VQT
• The Year in Safe Havens
• The VIX as a Hedging Tool
• Performance of Volatility-Hedged ETPs
• Comparing SPLV and VQT
• Performance of VIX ETP Hedges in Current Selloff
• Dynamic VIX ETPS as Long-Term Hedges
• Three New Risk Control ETFs from Direxion
• The Economic Data Cliff

Disclosure(s): none

Updates to VIX ETP Landscape: Add VIXH; Drop 12 UBS Products

Two thirds of 2012 passed before we saw the first new VIX-based exchange-traded product and it turned out to be an interesting one: the First Trust CBOE S&P 500 Tail Hedge Fund ETF (VIXH), which was introduced at the end of August. VIXH is essentially a portfolio consisting of 99-100% of SPY, augmented by a dynamic allocation of 0-1% of VIX options, with the amount of options determined by the level of the VIX at the beginning of each VIX expiration cycle. This is the first VIX-based ETP to included VIX options among its holdings and it is notable that this product bucks the recent trend and is an ETF instead of an ETN. There are other features of VIXH worth discussing and I will discuss these in future posts.

As the VIX ETP product space expands a bit, it also contracts a great deal, as UBS has elected to close 12 of its ETRACS ETNs, effective tomorrow, September 11, 2012. These UBS products failed to gain sufficient volume and assets to make these viable over the long haul, but when AAVX retires, it will do so with the best VIX ETP track record of all-time. This product was launched on September 8, 2011 and is up about 120% in the year plus since it was launched. [See ETRACS Volatility ETPs for the full list of ETPs that will be closed.]

The graphic below is my periodic update of the VIX exchange-traded products (ETP) landscape, using the y-axis to denote leverage and the x-axis to indicate target maturity. In addition to the explanatory notes in the key at the bottom, it is worth noting that I use font color to distinguish between ETFs (black) and ETNs (blue). Also, I have used a parenthetical one letter code to identify the issuer: B = Barclays; C = Citibank; F = First Trust; P = ProShares; U = UBS; and V = VelocityShares.

[As an aside, regular posting should resume again this week…]

Related posts:

• VIX ETP Returns for Q1 2012
• VIX Exchange-Traded Products: The Year in Review, 2011
• VXX, VXZ, XIV and ZIV During Eleven Months of a Sideways VIX
• A Monthly Comparison of VXX and VXZ
• Options on UVXY and SVXY Open Up New VIX ETP Trading Approaches
• Dynamic VIX ETPs as Long-Term Hedges
• ETRACS Volatility ETPs
• Four Key Drivers of the Price of TVIX
• Will TVIX Go to Zero?

Disclosure(s): long VIX at time of writing

What If Stocks Decline?

Successful investors are the ones that are always making plans for all sorts of contingencies, so it stands to reason that they should even prepare themselves for the possibility of stocks actually declining one of these days...

I was thinking about the coming correction in stocks and how to position my portfolio for that moment when equities once again feel the effects of gravity when I stumbled upon an interesting tool at ETFreplay.com that they call their Down Day Association Stats. In a nutshell, it looks at the performance of a group of user-specified exchange-traded products on those days in which a benchmark falls X%.

In the example below, I have chosen SPY as my benchmark, 2% (per day) as my threshold decline and 36 months as my lookback period. I looked at 25 ETPs that cover a wide range of asset classes and investment approaches.

Some of the results from the Down Day Association Stats are not particularly surprising. For instance, the long bond (TLT) and the dollar (UUP) have a strong negative correlation to stocks and generally perform well when SPY declines sharply. Some of the other bond choices (LQD, PCY, BWX) have been better at treading water than countertrending, but also show the benefits of diversification. The commodity choices were somewhat disappointing, generally managing to lose at best half as much as SPY, with crude oil almost matching the declines in the SPY to the penny.

Among the data points that surprised me were that the frontier ETF (FRN) fared better than the SPY in big down days, while real estate (IYR) fared worse.

Of course every decline in stocks has a different set of catalysts and puts different stresses on different asset classes, sectors and geographies, but as stocks continue to grind higher, be sure to make preparations for that eventual pullback, because when it finally does arrive, it will likely do so at an inconvenient time and with surprising swiftness.

Related posts:

• A VIX Risk Reversal
• Performance of Volatility-Hedged ETPs
• Comparing SPLV and VQT
• Performance of VIX ETP Hedges in Current Selloff
• Dynamic VIX ETPS as Long-Term Hedges
• Three New Risk Control ETFs from Direxion
• Frontier ETFs
• Some Favorite ETF Sites
• ETFreplay.com Brings ETFs Volatility and Charts Together Under One Roof

[source(s): ETFreplay.com]

Disclosure(s): long LQD at time of writing

A VIX Risk Reversal

With the VIX at about 14.50 as I type this and a large group of investors convinced that stocks are overbought and/or not properly discounting global macro risk, many are wondering just how to translate their beliefs into an effective trading strategy.

For those who think a long volatility trade is the answer, there is the issue of the significant contango headwinds, where a negative roll yield will pummel net asset values on VIX options and VIX exchange-traded products as a part of the daily rebalancing process, while VIX futures are subjected to a similar decay that reminds me a little bit of a dying helium balloon. Long story short: there is a huge daily penalty being assessed just for holding these long positions.

There are ways to minimize the effect of negative roll yield and typically one of the best of these is to work with positions that focus on the more distant months of the VIX futures term structure. This is generally why VXZ outperforms VXX over an extended period. Unfortunately for aficionados of VXZ, the negative roll yield between the fourth and seventh month VIX futures (VXZ buys the seventh month and sells the front month each day) hit a new record on Monday and continues at near record levels.

So what is a long volatility trader to do?

One trade that I somehow have never managed to highlight in my 5 ½ of writing about the VIX is a VIX risk reversal. A risk reversal is essentially a synthetic long position in which a trader uses options to create a position that is similar to owning the underlying, but typically ties up less capital in the process. In the case of a risk reversal, this means selling out-of-the-money puts and buying out-of-the-money calls. In many instances, the sale of the put options will finance 100% of the cost of the calls.

While the VIX is currently trading at 14.50, keep in mind that the best proxy for the price of the underlying for VIX options is the VIX futures for the corresponding month. So, with the September VIX futures at 18.95 at the moment, one could sell the September 18.00 puts for 1.50 and buy the September 24 calls for 1.05, pocketing the 0.45 differential. A more conservative trader might look to sell the VIX September 16 puts for 0.55 and use the proceeds to pick up a September 30 call for 0.55 or to defray some of the costs of the purchase of a more expensive call, such as the September 24 (priced at 1.05) mentioned above.

There are ways to turn this idea into a more aggressive trade as well. One approach is to morph a risk reversal into a leveraged trade in which more calls units are purchased than put units are sold. An example of this approach might involve selling the September 19 puts (which are currently at-the-money) for 2.15 and using the proceeds to purchase two contracts of the September 24 calls for 1.05 each.

A risk reversal also goes by other names, notably a long combination (or long combo) and, despite the name, is a high-risk trade that is vulnerable to the ravages of time decay. This trade is not for everyone, but can be a good way to generate significant long exposure with a minimal outlay of funds and sometimes no outlay of funds at all.

Related posts:

• Crazy VIX:VXV Ratio Chart
• Options on UVXY and SVXY Open Up New VIX ETP Trading Approaches
• Performance of Volatility-Hedged ETPs
• Dynamic VIX ETPs as Long-Term Hedges
• New and Noteworthy: VIXcentral.com
• Third Steepest Front-Second Month VIX Futures Contango Ever
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• A Monthly Comparison of VXX and VXZ
• Ten Things Everyone Should Know About the VIX

Disclosure(s): long VIX at time of writing

How Can the VIX Be 14 and Lower than VIN and VIF?

Many novice and advanced VIX followers are scratching their heads today, wondering why the VIX is down more than 5%, hovering around the 14.00 level, when the SPX is down 0.4% and all the major market averages are deeply in the red. More serious students of the VIX will also note that this drop in the VIX comes on a Monday, when the typical VIX “calendar reversion” is generally responsible for about a 1% pop in the volatility index.

The answer to most of these questions lies in yet another idiosyncrasy of the VIX: the roll. Quoting directly from the source, the CBOE Volatility Index (VIX) White Paper, we find these two important nuggets from pages 4 and 9, which I have presented here sequentially for easier consumption:

“The components of VIX are near- and next-term put and call options, usually in the first and second SPX contract months. ‘Near-term options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration. When the near-term options have less than a week to expiration, VIX ‘rolls’ to the second and third SPX contract months. For example, on the second Friday in June, VIX would be calculated using SPX options expiring in June and July. On the following Monday, July would replace June as the ‘near-term’ and August would replace July as the ‘next-term.’”

“At the time of the VIX ‘roll,’ both the near-term and next-term options have more than 30 days to expiration. The same formula is used to calculate the 30-day weighted average, but the result is an extrapolation of σ² 1 and σ² 2; i.e., the sum of the weights is still 1, but the near-term weight is greater than 1 and the next-term weight is negative (e.g., 1.25 and – 0.25).” [Emphasis added]

When I first posted about VIN and VIF back in March 2011 (VIN, VIF and an Obsolete VIX), I was stunned to learn how few investors, including savvy and experienced VIX fanatics, were completely unaware of these indices. At the time, the CBOE did not even refer to VIN and VIF on their web site, but they have since added a splash page for these two indices, along with the following brief comments:

CBOE maintains indexes that track the level of implied volatility from single SPX maturities.

Ticker VIN (VINX on Bloomberg) – nearer term SPX expiration used in VIX calculation

Ticker VIF – farther term SPX expiration used in VIX calculation

Getting back to the roll, the SPX options contract months roll forward one month today, so that the nearer-term month (VIN) moves from August to September and the farther-term month (VIF) moves from September to October. More importantly, per the bolded text from the VIX white paper above, today’s VIX calculations sum more than 100% of the VIN and a negative number for VIF. This is the reason why the VIX is less than the two components used in its calculation: VIN and VIF.  In summary, the bigger the difference between the VIN and the VIF (and right now that difference is a very large 9.4%), the more likely the VIX is going to be substantially depressed following the VIX roll.  Also, as we move toward the expiration of VIX options on August 22nd, the distortions from the negative VIF component used in the VIX calculations should gradually diminish, as the VIF weighting moves toward zero and then becomes a positive number.

For those who are interested in delving into the nuances of the VIX calculations, the CBOE’s VIX White Paper is the best place to start; the links below might also provide additional insight.

Related posts:

• VIN, VIF and an Obsolete VIX
• The Calendar Effect and Time Decay
• Rule of 16 and VIX of 40
• Ten Things Everyone Should Know About the VIX

Disclosure(s): long VIX at time of writing

Another Way to Play Short EUR/USD: Travel!

There are many ways to translate an opinion about the financial markets into a particular trade. Recently, I decided to act upon my belief that the euro would weaken against the dollar by booking a couple of weeks in Europe. The trader/VIXologist itinerary would have probably run something like Ireland > Portugal > Greece > Spain > Italy, but instead I elected to steer to the north, vising the Netherlands, Belgium, Luxembourg, Germany and the Czech Republic.

For the first time in many moons, parliamentary votes, etc., the markets were reasonably well behaved during my vacation and the VIX didn’t even make it into the 30s.

As someone who spends a great deal of time nine time zones away from the events behind the European headlines, I was somewhat surprised to see the relative calmness and lack of concern in the people I spoke with about the European sovereign debt crisis. This is not to say that the consensus was that the most difficult phases of the crisis were in the rear-view mirror, only that in due time, all would be sorted out and life would go on in a manner similar to the way it was prior to 2008.

That being said, I was surprised to see that in the sculptures above the Gate of Giants, which forms the entrance to Prague Castle, one forward-thinking artist had captured the essence of the discussions between the Troika and the Greek government…

Related posts:

• The Evolution of European Equity Risk
• Euro Volatility and Risk
• Chart of the Week: As Goes Spain...
• Chart of the Week: VSTOXX, VIX and the Risk of Global Contagion
• Expectations, Surprises and Fear in 2011
• Chart of the Week: European Stocks Holding Up Well
• Recent Performance Divergence in European ETFs
• Where and When Will the Euro Bottom?
• Greece, Spain and the Pulse of European Anxiety
• Why Not Point Hedges?

[photo: Gate of Giants, Prague Castle]

Disclosure(s): long VIX at time of writing

Crazy VIX:VXV Ratio Chart

There was a point in the history of VIX and More that I gave serious consideration to a regular feature in which I unveiled “Strange and Unusual Charts” that presumably had, apart from their novelty, the ability to shine some new light on at least one corner of the investment universe. That being said, I have always had an affinity for presenting charts that show unusual ratios, non-standard time frames and such and while the likes of Chart Porn and Unusual Chart of the Month: VXO and RVX did get me started down a slippery slope, I never quite fell into the habit of tilting wildly at windmills on the plains of StockCharts.com and their brethren.

One rabbit hole that I was definitely the first down and pursued the most aggressively was the VIX:VXV ratio, which one blogger insisted was sure to ultimately be my investing legacy. In all fairness, for the first year following the launch of VXV (essentially a 93-day version of the VIX), the VIX:VXV ratio performed as if it was going to make all other indicators obsolete. Of course, then the financial crisis of 2008 hit and the ratio began sprouting warts all over. While I talk about the VIX:VXV ratio only rarely in this space nowadays, the general idea of which the VIX:VXV ratio is just one instance of what has become one of the main themes of this blog: the idea that an understanding of the VIX futures term structure is critical to understanding the valuation of and trading opportunities available for all VIX products, including futures, options and exchange-traded products.

All of which brings me – somewhat belatedly, perhaps – to today’s chart, which is right out of the same cauldron that produced some of the curiosities of yesteryear. The chart below captures 2 ½ years of daily bars in the VIX:VXV ratio and adds some green Bollinger bands for color and context, along with a gray area graph of the SPX. Finally, I have included a purple line for the VIX:VXV ratio that reflects a 500-day exponential moving average (EMA) in order to show the long-term average of the ratio.

While there are many interesting nuggets buried in this chart, first note that the long-term average of the VIX:VXV ratio is not 1.00, but generally hovers in the 0.90 – 0.95. This reflects the fact that the VIX futures term structure has historically been in contango (upward sloping, with nearer months less expensive than more distant months) 75-80% of the time. Second, note that spikes in the ratio tend to coincide with bottoms in stocks and vice versa. Finally, note that even with the crazy VIX spike last August and September (and record backwardation, i.e. high VIX:VXV ratios), the ratio has been depressed since December and the 500-day EMA is now making all-time lows.

What does this mean? Lots of things, but in simple terms investors continue to believe that the VIX is unnaturally low given the scope and magnitude of the future threats to equities. Should the ratio continue at its current 0.83, I would be very concerned about the possibility of a bearish reversal.

[In order to keep this post to a manageable length, I have skipped over a bunch of related issues, but readers should feel free to wander down some of the same rabbit holes I have preserved in the links below.]

Related posts:

• VXV Heralding a Return to Normalcy
• 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
• VXV Is One Year Old
• The VIX, VXV and Volatility Expectations
• How to Create Your Own Portable VXV
• Thinking About VXV
• VIX Sets Two New Records
• 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
• Chart Porn
• Unusual Chart of the Month: VXO and RVX
• The 1000^th Post

[source(s): StockCharts.com]

Disclosure(s): long VIX at time of writing

Why VIX Puts Get Cheaper in More Distant Months

Today I fielded several questions related to the valuation of VIX puts – a subject that can be a head-scratcher for even the most seasoned investors.

The put matrix graphic below, courtesy of optionsXpress, shows bid-ask quotes for VIX puts from July (which expire at tomorrow’s open) through December.

With the VIX at 16.21 at the time of this screen capture, note that for the 17s the prices for August through December have already factored in some mean reversion. For this reason, the August 17s are the most expensive on the board, with a bid-ask midpoint of 1.05. The September 17s are quoted at 0.875; the October 17s are at 0.75; and both the November and December 17s are at 0.675.

One way to interpret this put matrix is that if you were to pick any month other than the current one that the VIX is most likely to close below 17, then August is your month. Additionally, if you expect to get any money for selling VIX 17 puts, then August is the best month to target.  This is because the moneyness of the VIX options considers the full VIX term structure and with the VIX futures in steep contango, the back months are a full nine points higher than the front month (July) VIX futures.

[As an aside, things get even crazier when trying to structure calendar spreads with VIX puts. In fact, the best way to think about these trades is to consider them not to be spreads based on one underlying, but two different trades based on two different underlyings: the VIX futures for each corresponding month. This details of this subject is fodder for another post.]

Finally, for those who might consider selling VIX puts – always an interesting strategy, but often with surprisingly little premium involved – the key risk management concept to consider is that the direction of the spike in the VIX is almost always to the upside and only rarely to the downside. Short of a QE3 announcement, it is difficult to anticipate the type of news which would push the VIX under 15.00 for an extended period.

For more on the VIX put matrix, the pricing of VIX puts and some of the strategic implications, check out some of the links below.

Related posts:

• VIX Put Matrix Offers a Glimpse of Expected Future
• Chart of the Week: VIX Support
• Selling VIX Puts with the Help of a VIX Put Matrix
• VIX Futures: What Were/Are They Thinking?
• VIX Futures Contango Soars
• More Strange Happenings in the VIX Term Structure
• Chart of the Week: VIX Macro Cycles and a New Floor in the VIX

[source(s): optionsXpress.com]

Disclosure(s): long VIX at time of writing; optionsXpress is an advertiser on VIX and More