A Disturbance in the Farce?
We usually like to keep an eye on indicators that are not getting a lot of attention, in an attempt to circumvent the “what everybody knows isn’t worth knowing” problem. Recently, several noteworthy things have happened with the $VIX, or rather, the derivatives traded on the VIX. The VIX is a measure of implied volatility, referring to front month options on the S&P 500 Index (it used to be the S&P 100 back when OEX options were still the most liquid index options – the OEX version is these days called VXO). While the first OEX version used only at-the-money options expiring 30 days hence, the calculation has been expanded over time. Now it is a blend of front and second-month at-the-money and out-of-the-money options. Those interested in the precise calculation procedure can take a look at it here: CBOE VIX White Paper (PDF). The aim is to calculate the expected 30-day volatility of the SPX at a 68% probability (one std. deviation) as expressed by the options market.
Image credit: James Steidl / Thinkstock)
For some time VIX futures and options that reference these futures have been trading. Both the futures and options are extremely popular, as hedging instruments, but also as speculative vehicles. In addition, there are VIX ETNs (both long and short, some of which are leveraged), which are also highly popular. Since the stock market usually becomes much more volatile when it goes down rather than up, the VIX tends to rise whenever the market declines. In a steadily rising market with little volatility, the term structure of VIX futures tends to be in contango. There have already been two occasions in 2015 when the cash VIX traded above the futures curve, and even now (after a strong market rise on Monday), the nearest futures contract trades above the two subsequent ones.
On two occasions in 2015, the cash VIX was trading above the level of VIX futures. The term structure remains partially inverted – click to enlarge.
VIX futures curve – although the cash VIX ended below the futures curve on Monday, March and April futures are still in backwardation vs. February futures – click to enlarge.
When the first inversion of 2015 occurred in January, the event was subject to what could turn out to be an erroneous interpretation at Business Insider. While it is true that over the past year or so, the curve tended to invert close to short term lows, it didn’t invert right at those lows, but before they were made. It is also the case that generally, over the longer term, VIX curve inversions are actually a negative sign, as Gavekal points out here (with a chart that shows a lot more history than the one in the BI article). Prior to the 2008 unpleasantness the VIX term structure also went into backwardation. It was obviously not a good idea to buy stocks at that juncture (it was a good idea to buy VIX calls though).
The recent episodes of VIX futures curve inversion are still small, and may well turn out to be meaningless, similar to those seen last year. However, one needs to keep in mind a few things here: With the sole exception of the October correction, these inversions tended to last just one day in 2014, and were as a rule followed by a divergence (a lower low in the SPX, while the backwardation disappeared). This year we have had two of them closely grouped together on rather mild declines. If the phenomenon turns out to be persistent and the backwardation steepens, then it will definitely fall under the header “warning sign”.
“No More Hedging Required”
Moreover, the event needs to be brought into context – namely into context with what has happened with VIX options. We were surprised to learn what has happened in terms of call vs. put open interest in VIX options in January, and how this was rationalized, according to a Bloomberg report :
“Even with stock swings nearly doubling since 2014 and U.S. equities poised for their worst month in a year, traders aren’t signaling too much concern.
Investors own about 2.4 million options betting on a rise in the Chicago Board Options Exchange Volatility Index, compared to about 1.6 million contracts wagering on a drop. That’s around the lowest ratio of calls to puts in more than two years, data compiled by Bloomberg show, indicating traders don’t anticipate an increase in market turbulence anytime soon.
This seems to be the exact opposite of what VIX futures are signaling, as backwardation in VIX futures is always a sign of “concern.” Here is more about why speculators and hedgers alike seem no longer willing to bet on a rise in the VIX – in spite of the fact that it has actually clearly moved into a higher trading range this year:
“Traders have abandoned options betting on jumps in the VIX since November, even as the gauge spiked at least 18 percent three times this month. Stocks’ tendency to power past declines at the end of 2014 encouraged traders to shed hedges and speculative bets in VIX options they weren’t profiting from, according to Todd Salamone of Schaeffer’s Investment Research Inc.
“We’ve seen a massive drop-off in call open interest,” Salamone, senior vice president at Cincinnati-based Schaeffer’s, said by phone. “There’s been the lack of a big selloff or major volatility pop that hasn’t been short-lived, which could be responsible for that.”
Individuals use VIX options as a tool to protect their stock holdings from losses or to speculate on increases in market stress. The VIX moves in the opposite direction of the Standard & Poor’s 500 Index about 80 percent of the time. Investors have dramatically reduced their positions in VIX calls since September, when they owned about 4.4 contracts betting on upside in the gauge for every put, the highest ratio since February 2007.
Open interest in calls has plunged 50 percent since then, while ownership in options wagering on a VIX decline has grown 49 percent. The put-call open interest ratio in the contracts fell to 1.4 on Jan. 23, the lowest since April 2012.”
We believe there is a lot more speculative interest in VIX calls than hedging interest, but that is just a hunch. We also believe that those trading VIX futures are more likely to be professional traders, as the futures obviously involve a lot more risk than the options; more risk than for option buyers that is – option writers are exposed to very similar risk as futures traders.
We find it quite remarkable that call open interest in VIX options has plunged dramatically just as the VIX actually seems to be threatening to break higher. This definitely strikes us as a bearish divergence. It also means that the behavior of the term structure is most likely of the “warning sign” variety. In fact, it is suggested in the article that the lack of protection via VIX calls may be exacerbating stock market volatility this year (as non-hedged longs are more likely to use stops):
“The frustration level has steadily grown as people see these spikes in the VIX become more and more fleeting,” Breier, a senior equity-derivatives trader at BMO in New York, said by phone.
The stock market’s durability last year could have led to investors shedding unused protection and never replacing it, Salamone at Schaeffer’s said.
“Those that typically use VIX call options to hedge long portfolios could be giving up on those hedges,” he said. Through most of last year, “it wasn’t unusual for 90 percent of those calls to expire worthless,” he said.
The consequences endured by underhedged investors may have already surfaced in exacerbated stock swings. The S&P 500 has posted average daily moves of 0.9 percent so far this year, almost double the 0.53 percent average each day in 2014.”
What’s more though, hedging activity seems to have moved away from the options market to the futures market, indirectly confirming our above assertion regarding VIX futures mainly being the playground of professional traders. Incidentally, some of the rising open interest in VIX puts is possibly explained by the increase in long positions in VIX futures. Once again though we think one should not underestimate how much short term speculation there is in VIX options. It is as though traders in these options have “learned their lesson” and are now increasingly betting on declines in the VIX – quite possibly at exactly the wrong time:
“Even as VIX options traders give up on calling for more turbulence, hedge funds and other large speculators own the most such bets in VIX futures contracts since December 2009, according to data compiled by the Commodity Futures Trading Commission. These managers held about 86,700 long positions and 79,700 short ones through Jan. 20, CTFC data show. Hedge funds are expressing the view that volatility will gradually rise this year without trying to time when the VIX will spike, according to Dan Deming at Equity Armor Investments.
“Right now, there’s a belief from a trader’s perspective that owning VIX futures is a better strategy,” Deming, managing director at Equity Armor, said by phone from Chicago. Larger market participants “are buying downside puts because they’ve ramped up their volatility exposure,” he said.
The two most-owned options on the VIX are wagering on it to decrease within the next 30 days. Contracts expiring Feb. 18 with a strike price of 14 have the highest ownership, followed by options wagering on a drop to 15 by that same day.
Something has clearly changed – but the one factor that is most unlikely to have changed is that the options crowd will be wrong again. If so, then the VIX is set to rise.
Investors and traders should keep a close eye on the VIX term structure and the put/call open interest ratio in VIX options. The term structure can be followed here, at VIX Central. Charts summarizing various VIX options-related data can be found here. If these recent trends persist, it could well prove to be meaningful.
Addendum: Bonds vs. Stocks
Here is one more chart that deserves to be looked at from time to time, and now is such a time. It plots the ratio of the 30 year treasury bond price vs. the SPX. As you can see, whenever this ratio has “broken out” to the upside, it too warned of an impending increase in market volatility. Its current rise may yet turn out to be a flash in the pan, but this also bears watching closely:
The ratio of the 30 year treasury bond price vs. the SPX – it seems to have bottomed in 2014, and now it is rising. So far the increase is small, but it may well turn out to be an early warning sign as well – click to enlarge.