Contrary to what many may think, crashes in the stock market do not just suddenly happen without warning. The subprime crash, flash crash, 2011 debt ceiling -- all of these events were preceded by weakness in the market well in advance of an actual crash event. While it is impossible to predict when the market will see a correction there are ways to identify that the market is on edge, where one of many possible events can trigger a downdraft. (There is an excellent book by Mark Buchanan (Ubiquity: Why Catastrophes Happen) which goes in to depth on the topic of how something seemingly small triggers large chain reactions.)
One of the signals that I use to determine when there is tension building in the market is to look at where front month VIX futures are in relation to the spot VIX. For reasons I will describe below, a positive premium of front month (M1) over spot VIX normally exists and converges over time. Abnormalities of this behavior indicate shifting investor sentiment.
The first concept to understand is that while spot VIX is the current 30-day measure of implied volatility of SPX options, VIX futures are the measure of the expected implied volatility on the expiration date for a given month. This means that the front month VIX futures is further out in the future than the spot VIX. Once the expiration date for the front month is reached it expires and VIX futures roll over to use the next month as front month.
The second concept is that the prices for each month of VIX futures create a curve called the term structure. Normally the VIX futures term structure is shaped such that contracts for near term months are more expensive than contracts further out in the future, a condition known as contango. In the graph below you can see a visualization of the term structure via the closing prices of the first seven months (M1 through M7) of VIX futures for the previous five trading days.
(click to enlarge)
By combining these two concepts you can see that there is usually a premium of M1 over spot VIX since M1 is further out in the future and the term structure is in contango. Since spot VIX is a constant 30-day measure of volatility and M1 is forward implied volatility on a fixed day for the next month, the amount of premium gradually decreases as we approach the expiration date.
The chart below provides a 55 month view of the daily reading of the percentage of M1 above (or below) spot VIX. Note the periods circled in red where the value go briefly and shallowly negative followed by a spike downwards where VIX becomes much larger than M1 as the markets sell off and traders drive up the value of the spot VIX. This can be contrasted by the more confident periods in which spot VIX remains above M1 for a prolonged duration indicating a more confident market (see green "floors").
(click to enlarge)
The downdrafts identified on the charts started on the following dates:
1) 9/9/2008 (subprime crash)
2) 5/6/2010 (flash crash/Greece debt problems)
3) 3/16/2011 (Libya skirmish)
4) 7/27/2011 (Debt ceiling crash)
As you can see, the market provides useful signals when sentiment is changing and is starting to get unstable. As market sentiment changes for the worse, you can see a gradual change in the term structure where the spot VIX rises above front month futures, a condition defined as backwardation. There will be occasional periods of slight backwardation before a more pronounced upward move in the spot VIX which is typically accompanied by a marked downturn in the market.
These movements are not just a coincidence -- they explain investor sentiment. When the broader market is doing well, investors tend to get complacent and expect that it will continue to do well. They continue to add to long positions (often with leverage) and do not have much interest in buying and holding options for protection. However these brief dips into backwardation suggest that options are underpriced and set to rise rise after a series of events remind investors of the existence of broad market risk. They start buying protective puts, initially in smaller quantities and holding only briefly, followed by broad buying of protection thereby driving up both spot VIX and VIX futures as market risk materializes.
For investors of the S&P 500 (NYSEARCA:SPY) and broader market this may mean that extra caution is warranted in the coming month(s) as we repeat the cycle.
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. I have no business relationship with any company whose stock is mentioned in this article.