In the week since my September 27 article on volatility hedges the equity market has weakened further and the volatility ETFs, ETNs and the VIX index have continued to climbed. Even with the stock market recovery and the volatility decline of Oct 4 the VXX is up over 10% in one week. At the market close Oct. 4 VXX closed at 52.84 up from 47.64 from the Sept. 27 market close. The VXZ rose from 68.83 to 71.98 over the same period while the S&P 500 dropped from 117.54 to 112.34.
As the equity market has turned more volatile and the VIX continues to rise rapidly, a further market development has turned to favor holders of the volatility hedge instruments such as VXX. The term structure of volatility futures has moved from contango (further dated futures more expensive than nearer dates) to the opposite condition: backwardization. This occurred during the stock sell-off/VXX rally in August and was a positive for the VXX then.
The curve moved to contango again in early September but has returned to backwardization later that month as can be seen in the charts below (Sept. 1 chart top, Oct. 3 bottom).
Click to enlarge charts
Why is this change in the term structure important for those owning VXX and VXZ and similar instruments (VIXY, VIXM)? For most of the time that these instruments have existed the futures on the VIX futures have been in contango. What that meant for the VXX is that it had “roll cost” as it has to sell the near date futures as they approach expiration. This contango has been very painful to long-term holders of these instruments. In fact many experts have written off these instruments completely. As the folks at ETF Trends noted, those critics were wrong in writing off the VXX and VXZ. In fact, these types of instruments can be very good tools in severe market downturns.
I wrote in detail about the term structure of VIX futures as long ago as May 2010 and at the time noted that the futures tend to trade in contango with the VIX up to levels of 25 and in backwardization at higher levels. In that article I noted that when the VIX is from 15-20 the spot to one month futures averaged plus 4.02 (contango). At levels of 40-45 it averaged -9.95 (backwardization). For the differential between one to two months futures, the numbers were 1.64 and -4.11, respectively.
The 1-2 month spread was Oct. 3 at the close -1.18 (slight backwardization). Oct. 4 it moved to +.59 (slight contango) while the cash to near date spread is near zero.
The cash VIX closed at 40.82 on Oct. 4. Should historical pattens hold, even with a slight fall or stabilization in the VIX, the volatility curve could remain high or even steepen. This would be a further supportive factor for volatility hedges such as VXX.
Also the VXX has moved to a premium over the cash VIX, something that has not occurred any other time this year for more than extremely brief periods (see below). This of course is another positive for the VXX holders.
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Some stock market analysts see the extreme levels of the VIX as a signal of an oversold market and a buying opportunity for the stock market. I won’t venture a market timing guess on that one. But the macroeconomic factors that are causing market turbulence have certainly not been resolved. And the internal dynamics of the VIX futures which effect the pricing of the VXX and VXZ have turned more positive as of late.
In an element of irony, Pro Shares launched versions of its weapons of self destruction, a daily inverse ETF (NYSEARCA:SVXY) and daily 2x inverse VIX ETF (NYSEARCA:UVXY) on October 4. Buyer beware.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VXZ over the next 72 hours.
Additional disclosure: Mr. Weinman's clients have positions or may initiate positions in VXX VXZ VIXY VIXM. Mr Weinman has or may initiate positions in VXX and VXZ.