Volatility Players: Backwardation Imminent?

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Includes: TVIX, UVXY, VXX
by: Josh Krause

So, it appears the markets are not quite as sure as they were on Friday that Bernanke and the German Supreme Court will deliver the goods later this week. After continuing to trend down after Europe closed on Friday, we finally saw the rush for protection that caused a significant spike in spot VIX.

Hedging in front of such significant events is just common sense so I am not surprised at the surge off the lows we saw yesterday. What is surprising is the flatness of the term structure and what that could mean for long volatility positions.

Uncanny Valley

A quick look at the term structure for volatility shows that we are getting dangerously close to entering backwardation in VIX futures.

Spot VIX: 16.28

September Futures: 16.50

October Futures: 18.55

With only 1.4% separating Spot and September, we remain at an attractive position if VIX continues higher. Even the September vs. October gap has narrowed down to 12.4% which lowers the damage done by Contango by almost 25% compared to what we saw on Friday. Any positions started at Friday's or Monday's lows should be easier to hold now that the term structure has flattened and the VIX continues to approach backwardation.

A quick look at the chart for spot VIX shows us that we could have more room to go as people continue to hedge and prepare for any possible disappointments.

VIX 6 Month PerformanceClick to enlarge

Even though futures are currently green, we could easily see spot VIX heading to the 50SMA at 16.58 or higher as puts are purchased throughout the day. I don't see us heading much above this small level of resistance through typical hedging, though any rumors or hints that the court will rule unfavorably could take us up to the 100SMA on panic put buying.

The first decision point will be tomorrow when the German Supreme Court announces their decision to grant the ESM a banking license. If they do as the market expects and approve the license, we could see a dip in volatility that should recover as the market prepares for the FOMC meeting and the possibility that Bernanke might disappoint instead.

While Wednesday will be dominated by the German Supreme Court, Thursday will be the Ben Bernanke Variety Hour. At 12:30PM EST we get the FOMC statement and the rate decision. As rates are already at zero, the most we could get is an extension into 2015 for the commitment to low rates. Whatever the outcome of the statement, the real fireworks will start at 2:15PM EST when Ben Bernanke grabs a microphone and starts spitting his version of the truth.

In addition to these events there is a slew of industrial, manufacturing and CPI related data but the market moves on the decisions of Central Bankers now. The printing press has been the deciding factor in recent market movements. While each is relevant and with few exceptions are trending negatively, the will he/won't he for Bernanke and the German Supreme Court will govern the majority of the hedging activity this week.

Plan of Attack

Hedging will continue until morale improves, errr I mean until the announcements are publicized. The uptrend in volatility that we saw on Monday should continue, though to a lesser degree, into Tuesday. A quick search for an exact time for the ruling on Wednesday turned up nothing so any prudent traders not willing to roll the dice on ESM rejection should look to exit before the close today as we could easily have a decision before the market opens tomorrow.

If the ESM is approved, we could see a sell the news event but more than likely it will further lower concerns in the EU and add to the risk appetite. I would expect VIX to drop intraday and then pop back up as people realize that Bernanke controls the remainder of the punch bowl on Thursday.

To get past the resistance we have seen in spot VIX we would have to see a failure in both events. With the current term structure, any such major disappointment will lead to outsized gains in VXX, TVIX and UVXY. If you are an aggressive trader and believe that the markets are going to be disappointed in the outcome of these upcoming events, you should be looking to add to long volatility positions while we are still at these relatively depressed levels of volatility.

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.