Volatility Players: Treacherous Gaps

Includes: TVIX, UVXY, VXX
by: Josh Krause

In one day we went from a relatively flat term structure in VIX futures to the steepest I have seen in quite some time.

We started Friday with the following structure:

Spot VIX: 18.33

Front Month Futures (Jul): 18.50

Next Month Futures (Aug): 20.60

Out Month Futures (SEP): 22.45

This was a relatively flat structure with a 2.37 (8.7%) gap between Spot and Aug futures. Much better than what we saw in front of June futures expiration when the gap was closer to 2.60 at nearly the same levels. The smaller the gap, the less contango we have to deal with and the more likely we will be able to capture outsized gains by playing the volatility products.

Going into yesterday I wanted to make sure everyone was careful in front of what I felt was a soft period for volatility but I had not imagined that the environment for long volatility trades would shift so drastically in just one trading session.

What A Difference A Day Makes

After Friday's action we now have the following structure for VIX futures:

Spot VIX: 16.74

Front Month Futures (Jul): 17.45

Next Month Futures (Aug): 19.32

Out Month Futures : 21.43

At the closing bell on Friday the gap between Spot and Aug futures had risen to 2.58 (13.3%) and the gap between spot and Jul futures set to expire on Tuesday rose from 0.17 to 0.71.

Since VIX products are futures based and gradually shift over time from front month to next month futures contracts, the impact of this increased gap should be minimal but the steepness of the curve bears consideration. With only 2 more trading days to go before July expiration, short term volatility products like VXX should have already shifted the majority of their contracts into August by now.

The steepness of the "curve" or "structure" in volatility contracts will determine the impact that contango will have on a long volatility play. The larger the difference between contract prices, the more you will lose as time passes and VXX rolls their contracts into the next month.

Since the curve has steepened, we could see an 8% decrease in front month futures without any move in spot VIX just to get us back to the structure we had 24 hours ago. Anyone considering getting long volatility now that spot VIX has dropped into an attractive position needs to understand that the term structure for VIX futures is now actually worse than before.

Does a spike in spot VIX have a chance to cancel out this reiteration of a cautionary call?

Of course. Volatility depends on headlines and we are in a market environment that is ripe for massive headline movements. We are entering a very interesting time in the markets with last year's cliff diving being used to justify calls for a repeat of the same this year.

Anyone trading VIX needs to understand that even if VIX moved from where we are now to 18, we could see much less movement in the futures due to the steeper structure. While the spot VIX could see a 7.5% increase, futures may only move 5% in response if we go back to the term structure from Thursday's close.

Trading VIX is all about risk vs. reward if you are going to try swing trading in these markets. When the term structure is steep, your ability to make outsized gains is greatly reduced. Intraday trading can ignore it to some degree but anyone contemplating holding VXX, UVXY or TVIX overnight needs to be constantly aware of the term structure and what that means for the viability of the trade.

A Look Into the Crystal Ball

Eventually we are going to see the VIX term structure flatten. Whether that means an increase in spot VIX to 17.64 (back to the 8.7% gap), a fall in August futures to 18.81 or something in between there is a strong likelihood that anyone betting long volatility in the near term will not like the outcome.

Holding spot VIX steady at 16.74 is a way to make this easier to model but the recent rejections at the 100 day simple moving average leads me to believe that we are headed to new lows in spot VIX on Monday with possible continued momentum into Tuesday. Any time frame beyond that and we're throwing our darts too far to make the target.

With a steeper than average term structure and the potential for more weakness into next week, I believe that now is not yet the time to start new long positions in volatility and that we will see better entry points soon.

My desired target for spot VIX is a dip into the 15's and a flattening of the term structure. At that point many longs will have been shaken out and the real shenanigans can commence.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.