VIX and More: October 2012

Wednesday, October 31, 2012

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:

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)
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?

[source(s): CBOE]

Disclosure(s): none

Monday, October 29, 2012

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.

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

Monday, October 22, 2012

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.

Disclosure(s): none

Sunday, October 21, 2012

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:

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

Tuesday, October 16, 2012

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.

Disclosure(s): none

Sunday, October 14, 2012

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.

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.

Disclosure(s): none