VIX Volatility Issues Are Now Playing A Confusing Game

by: Peter F. Way, CFA


The VIX-index securities involved here and the issues they represent are a sophisticated sector of the equities markets. For many investors, one worth knowing about, but not participating in.

They deal overtly with the potential for change in the current trend of major equity price indexes.

Such directional changes heighten investor uncertainty, and uncertainty inadvisedly has been linked to investment risk in professional preaching, which casts an emotional flavor into the evaluation.

Investor risk perceptions rationally are uni-directional – typically involved with loss of capital, while uncertainty involves unexpected surprises, both good and bad.

Separating uncertainty’s cohabitants confounds many in the investment community, but least bothers those skilled in the art of arbitrage. Still, it is a realm of capacious opportunity – and risk.

What's happening now?

Investment volatility's center of interest, the VIX index, has been getting lower and lower.

The VIX Index infers uncertainty about the direction of coming price changes in the principally accepted equity market price measure, the S&P 500 stock Index. That is done by reversing the usual process of combining the factors used to determine the appropriate trading price for a stock option. In the place of the key option value input variable of uncertainty, the actual price of the option is substituted and the missing dimension of uncertainty is solved for, among the many related options contracts for the subject. The pro jargon is "implied volatility" and traders of options use it as a timing tool.

When the VIX index calculation produces a low number, say 10 to 15, the inference is that investor notions about prices of the subject of the options (here the S&P 500 index) are reasonable, and the market is not troubled about present stock values.

But just as nature abhors a vacuum, the market abhors OVER-confidence. There are always surprises that can arise; it is the unexpected that can cause damage because it is not prepared for. The paradox is that too much confidence creates concern, sometimes to the point where minor troubles get magnified into great worries and rampant uncertainty takes over, in worst cases as a panic.

The market (actually its human inhabitants) becomes its own spoil-sport.

The VIX index has recently dipped as low as 13, while being as high as 28 in mid-February. For some this move is nervous-making, although in its over 25-year history prices below 10 have occurred.

Market intricacies spell out how nervous it gets

Besides options trading on the S&P 500 Index, there are futures traded on the index. That presents a time sensitivity to how the index might move in price over coming months. When market confidence for the future is high, the market index futures are rising.

There are also futures trading on the VIX Index itself, and they have a parallel implication for the VIX to the market index's implication. That should seem disturbing because when the stock market goes down, uncertainty rises and the VIX Index goes up.

But just as too low a VIX index makes some nervous, if the time-structure of the VIX futures is rising, that is a reassurance that while the present may be disconcerting, it is recognized, and over a gradual, non-disrupting time passage, the VIX should rise back to a more comfortable level without causing a panic. Professional jargon for this condition of rising VIX index (or any) futures quotes is "contango."

So, what happens if eventually market concerns rise to a level where the VIX index rises, from say 13 to 15 and then goes even higher? What happens to the VIX futures curve? It may go flat as the near end reflects the "spot" or current VIX index calculation, while the far end remains close to where it was earlier.

What happens next is dictated by the investing attitude environment, triggered by many diverse influences, rarely predictable with any reliability. If the situation settles, the VIX may go back towards or beyond 13 and the futures time structure may revert to its prior contango shape.

But if many fears hit the fan together, the VIX index will rise precipitously, dragging the near end of the time structure and its intermediates in its upward direction. Now the time structure is in "backwardation" with near futures priced higher than time-distant ones.

The VIX tends to run to extremes. A "high" VIX can be 50 or more, or may top out at 30, no telling for sure. But a clue as to what may happen next, as it is about to happen, lies in that shape of the VIX time structure.

A high VIX, because of a plummeting stock market, always returns to "normal." But how soon it will do that, and the stock market itself will recover, is hinted at by the VIX time structure going back from backwardation to flat to contango.

And where are we now?

The VIX Index has just come up off of its 13.1 low to 15.6.

Because market professionals use derivatives of the VIX Index to arbitrage broad market risks in the same manner as they do when market-making [MM] on specific securities, we have the same kind of forecasts for the VIX that we have for each of the Dow 30 components and for over 2500 other stocks and ETFs. Here is how the MMs have been looking at the VIX during the past 6 months, daily and then once a week over the past 2 years.

Figure 1

(used with permission)

It should be clear from both the 2-year weekly historic forecast expectations ranges pictured immediately above, and from the thumbnail picture beneath the 6-month daily forecast picture, that VIX range expectations do not follow a path typical of ordinary stocks or market indexes.

VIX expectations tend to "live" at low levels and get intermittently perturbed into high anxiety as a result of S&P 500 Index price declines. The thumbnail picture is a distribution of the past 5 years' daily Range Indexes. The Range Index [RI] measures what proportion of a day's hedge-derived price range forecast lies below that forecast day's market quote. For the VIX this clearly is not a traditional bell-shaped curve, the way it is for many stocks or ETFs.

VIX Index prices are a resultant, not a cause of stock price changes. After perturbation they work their way back to their usual low levels as markets "get over it" and recover. Those market recoveries are valued opportunities for asset allocation to emphasize the proportion of the portfolio dedicated to equities.

A signal of the onset of market recovery is a valuable resource. It may be found in the time-structure curve of VIX Index futures, as that curve reverts from a market-panic type of backwardation to flat and then increasingly, to the contango shape.

A valuable generalized source of this information is provided without charge on the internet at Trading Volatility, which produces the type of display shown in Figure 2.

Figure 2


This is a website serving sophisticated investor-arbitrageurs by subscription, with complex, valuable relationships beyond the needs of most individual investors. But it has chosen a presentation that has usefulness well beyond its principal intended audience. They have our thanks, and respect.

As may be seen at the pictured point in time above, the VIX term structure provides a reassurance that although the VIX index is down in nervous-making (for some observers) territory, there is little immediate reason for concern over equity market valuations, as they are considered by these sophisticates.

What are the prospects for VIX-based ETFs?

That is too big a job for the scope of this article because of the number and complexity of that set of ETFs. We expect to do another study article of their prospects soon. But to give a simplified illustration, we present how the Market-Making community, through its hedging actions in one typical VIX ETF, have viewed, and are now viewing the situation.

Figure 3

(used with permission)

These Block Trader Forecast [btf] history pictures show the natural inverse relationship of the VIX Index prices and those of the tradeable iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) with the S&P 500 Index. For most investors the gain opportunities in VXX are relatively unpredictable events with short windows for profit - they are trading events, not investing holdings over usual commitment periods.

The recent-day upturn in expectations and prices on 4/5/16 raise questions in some circles over the absolute price levels of the S&P 500. Given world, local, political, and sociological developments, "Nervous minds want to know."


We find it reassuring that well-informed, experienced, highly-compensated professionals who are skilled in arbitrage continue to make bets that apparently deny any impending doom for equities.

But then, our mileage may vary, from time to time. The world is not a perfect place. That's what keeps it interesting, and worth sticking around.

Disclosure: I/we 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.