by Agustino Fontevecchia
Volatility slapped markets in the face on Monday, surging 50% in its biggest one-day move since February 2007. Furthermore, the whole VIX futures curve has been inverted and is in backwardation, indicating we’re in a fully fledged bear market, according to market experts.
Dubbed the fear index, the VIX, which measures volatility via options premiums for S&P 500 equities, behaved just as crazily as it did during other systemically important shock events, like the 2008 financial crisis, the fall of Bear Stearns, the flash crash of 2010 and the 2007 credit market meltdown, according to FT Alphaville.
Indeed, the VIX hit absolute levels not seen since the May 2010 flash crash, when it reached 48 on May 21, 2010, according to Dow Jones. The VIX term structure has actually flipped and is now in backwardation, after having been in contango only a few weeks ago, when the S&P 500 recovered from a small correction back on July 22, as VIX and More showed. The VIX has spiked 174% since then while the S&P 500 has declined 20.2%.
What’s VIX telling us?
VIX Futures term structure shift - vixandmore.blogspot.com
Larry McMillan, founder of The Option Strategist newsletter and the head of the research firm that carries his name, noted, “VIX backwardation is a clear illustration of a fully fledged bear market.” Highlighting that this was the first true inversion since March 2009, McMillan added that until the VIX futures curve flattens out, things will continue to look bad and the bear market will continue.
“[VIX backwardation] across the entire curve usually only occurs during systematically important shock events such as the 2008 financial crash, Bear Stearns bankruptcy, 2010 flash crash, and the 2007 credit market meltdown,” said Christopher Cole, managing director at Artemis Capital Management, to Alphaville.
Cole added that full curve “negative convexity” has only occurred 13% of the time since 2004, and, despite having an average duration of only 4 days, has been dragged out up to 64 consecutive days, as happened during the 2008 financial crisis.
With the Dow declining 605 points on Monday, after having tanked more than 500 points last Thursday, turmoil is definitely spreading through markets, as economists like Nouriel Roubini, dubbed Dr. Doom, calling for a double-dip recession. Cole suggests that the VIX’s inverted curve structure could mean the market is expecting volatility to revert back to the mean, or it could signal traders cashing-in on tail risk protection bought before the recent correction. (Read After ECB And G7 Commit To Intervene Markets, Will Bernanke Enact QE3?).
McMillan rejects this explanation, noting “the term structure of options always behaves in the same way, with the long-end of the curve exhibiting less volatility than the short-end.”
While no one can deny that the first downgrade of U.S. sovereign debt, courtesy of Standard & Poor’s, is a “systemically important shock,” Andrew Laubie, trader for AMR Capital Trading, told me “the probability that the market keeps tanking at the same velocity in the short run would only be contingent on additional bad news in that backwardation time frame, yet what more bad news can we get? Another U.S. downgrade? The only real risk is a European default.” (Read JP Morgan Economist: QE3 Only If We See Deflation, Equities Will Finish 2011 Up 8% To 10%).
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