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The Volatility Curve Is Changing, Sounding Some Alarms

|Includes: SPY, SVXY, UVXY, iPath S&P 500 VIX Short-Term Futures ETN (VXX), XIV

Brief:

  • The Volatility curve is changing, moving a bit closer to backwardation
  • Contango Yield is not attractive at current levels of 9%
  • Looks like market is re-pricing risk after a long period of cheap insurance

So, finally, the volatility curve is changing...

Looks like the sell off of Tuesday (The first 1% down after so many sessions) is finally convincing the market to re-price risk, as measured by volatility futures and their respective ETPs.

The spread between April and May VIX Futures sort of collapsed in the last couple of sessions, from a full 1 point to 0.66 points by the closing of Wednesday session.

The strange and alarming thing at the same time is that the spread held tight during the Tuesday sell-off, but collapsed today, Wednesday when the market was much calmer. This is not a good sign and is probably signaling a higher probablity of trouble ahead and a bit more sell-offs/increase in equity volatility in the near future.

This narrowing of the spread indicates a much tighter contango/roll yield, which stands at 9.15% as of close of Wednesday session. Vixcentral.com calculates the contango yield to be 4.8%, which I don't agree with as my calculation is different and is not really a matter of rounding differences, mine is almost double what they have.

I calculate the roll yield (contango yield) using the difference between the 30D synthetic future and the spot VIX. As of Wednesday closing, the 30D synthetic stood at 13.98. I do a small approximation in my calculation which does not affect or distort the final value a lot.

So, what does all of this tells or implies?

It implies simply that short volatility strategies, mainly focused on capturing the contango yield is in danger. The yield is not sufficient or worth taking the risk, that's one. Two, the yield itself is dynamic and changes even on an intraday basis, so if the yield shrinks further than that (A high probability now given the F1/F2 spread collapse), the yield will completely disappear, which can lead to short vol strategies bleeding money until we are back again.

My outlook for the market is still overall & generally positive for the rest of the year and until the end of Q1 2018, however, seems that the calm period is about to end.

Issue here would be the reaction of the market as it will be magnified given the long period of low volatility. Another 2% drop in the market in 1 session and VIX shoots up by 20%. A stretch of a string on 1 side causes it to over stretch on the other side when released.

My recommendation for now is to lighten up considerably on any short vol positions. I won't say that a long vol strategy at this point would be favourable either. Maybe it looks like a very good risk/reward trade, but as usual, it might easily turn sour. Any long vol strategy now should be kept to the shortest possible life span.

It's also worth mentioning that the farther part of the volatility curve is actually doing the opposite, July/August VIX futures spread actually rallied strongly today reaching 0.45 points. If a 1 day worth of trading indicates, it indicates that the VIX futures market is increasing an equity correction in April/May but back to normal again in June/July and forward.

Disclosure: I am/we are short APR/MAY VIX FUTURES SPREAD AND LONG APR VIX PUTS.