Volatility Players: The Roar Of The Dragon

Includes: TVIX, UVXY, VXX
by: Josh Krause

After being lulled into a coma by a boring market, I have been awakened by the screaming roar of the Italian Dragon, Mario Draghi. Yesterday was the latest defining moment for the head banker of Europe and the markets appear to have fallen in love. Closing at the highs in equity indices and lows in volatility, we have entered a market where hedging is unnecessary as the bankster brigade will support any downtick in the markets.

As an observer of history, I am always skeptical when it comes to the efforts made by Central Banks to juice economies. The printing press has a poor track record in supporting sustainable growth and I feel that we will see a repeat of central bank failure at some point in the future. The problem is that we still have plenty of road left for can kicking, especially if Trogdor's comments of bond buying power being unlimited are accurate. If the ECB is granted such power, making big bets against the CB Mafia is likely to be a bad idea in the near to medium term.

Before we give up entirely on trading volatility, let's take a look at the term structure and see where we stand.

Flat as a Board

After yesterday's action we are to a term structure that is extremely flat, especially on the spot/front month gap:

  • Spot VIX: 15.60
  • Sep Future: 16.10
  • Oct Future: 18.55

Going into today we have only 3.2% separating spot and front month futures, which is extremely low while we still have seven trading days left in the September VIX contract (Expires 9/19). This would promote a bullish sentiment for volatility if not for the large gap in front to next month futures of 15.2% that counteracts said bullishness.

Reading the tea leaves of the futures contracts, it appears that the market is pricing in a "Yes" vote by the German Supreme Court and approval of QE by the FOMC. To be so extremely flat on the September contract in front of such potentially market moving events, we can see that the market is almost 100% confident that Germany will capitulate and allow the ECB to leverage ESM money while the Fed prints dollars to support the U.S. and global markets.

There is not much time between these decisions and the September contract expiration, so whatever uncertainty that exists on the fallout of these decisions is being priced into the October contract. Since the main volatility trading vehicles (VXX, TVIX, UVXY, etc.) are all based on both front and next month futures, you can't go by the spot/front month gap without also considering the front/next month.

Sleeping Beauty

After making a recommendation to nibble at volatility in August, the VIX entered into Goldilocks territory with spot VIX going sub 15 for a short time. This matched the sleepy action that was then seen in the markets and only turned around as people hedged in front of Jackson Hole and the ECB meeting.

We could see the same sort of uptrend starting next week in front of the FOMC meeting and German Supreme Court decision. The small gap between spot and front month would allow the September contract would move up right along with Spot VIX as people began to hedge. Even if that happens, there may not be much movement in VXX and friends. Since we are well into September now, all of the short term volatility trading products are more than 50% October contracts and any movement in the September contract will be muted compared to the already elevated October contract.

I can support a long volatility position that is initiated after Europe closes today for a move in front of the FOMC meeting next week but I would not commit much capital to the position. There should be some hedging in front of the event but we may see the market relax further which could have us treading water.

Anyone going long volatility after the FOMC meeting generates QE and the German Supreme Court gives the go ahead should immediately re-evaluate their position. With a 15% gap in between the monthly contracts, that could be removed from your position if the VIX maintains the current structure. That is ignoring the possibility that VIX could head even lower as election euphoria and central bank support brings us back into Goldilocks territory below 15 in spot VIX.

Volatility will come back to the market, that is guaranteed, but you can't afford to be stubborn when trading volatility. Depending on the actions of the CB Mafia and German Supreme Court, we could see a dip in volatility to levels not seen since 2006. Even if that happens, it will just provide volatility players time to gather dry powder for the inevitable spike. With the fiscal cliff, massive tax increases, upcoming US debt downgrades and another potential debt ceiling fight, there are still icebergs lying in our path even if we may have a few months of calm waters in front of us.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.