Equity Volatility Remains Bid

Summary

• Absolute volatility remains high.
• Volatility term structure remains bid.
• Volatility skew inching higher.

The US equity benchmark S&P 500 has rallied ~40% from its March 23 lows and reflects the prevailing narrative of a "hope" phase (as described by Raoul Pal, founder of RealVision). While price action is the ultimate arbiter of a prevailing sentiment, it is no denying that coincident indicator - like volatility - has not subsided materially and forces me to have a cautious outlook to equity markets in the near to immediate term.

Absolute volatility in the >90%tile bucket

Since VIX peaking at 85.47 during the madness of March 2020, absolute volatility has trended down. But a VIX value > 28 still falls in the >90%tile bucket. And as of writing this note, VIX future contracts until Feb 2021 are still priced > 28. 

VIX futures term structure in backwardation

Under a normal scenario, the curve is in contango i.e. contracts are more expensive farther out into the curve pricing premium for uncertainty in the future. When the curve flips into backwardation, it indicates demand for near term protection relative to the longer maturity contracts i.e. an indicator for risk off sentiment. 

As you can observe in the chart below, the front end of the futures curve flipped from contango to backwardation on Feb 24th and steepened drastically during the crash of March 2020. 

Source: vixcentral.com

Since start of June 2020, the front end of the curve has been doing flip-flop between minor contango and minor backwardation while the backend of the curve remains in steep backwardation.

Source: vixcentral.com

Cash VIX term structure flip-flop between contango and backwardation

Cash VIX term structure includes the ratios - VIX9D/VIX, VIX/VIX3M, VIX/VIX6M. As with VIX futures term structure, the same logic of contango and backwardation extends to Cash VIX term structure also. Periods of market stress are reflected in a contango state for these spreads i.e. a ratio > 1.

The near term spread VIX9D/VIX remained in contango for a few days i.e. from June 11 - June 17 2020 (highlighted by the arrow in the chart below), and the other spreads in backwardation but very close to 1. But throughout the remainder of month of June 2020, all the spreads remained < 1 but close to 1, to indicate heightened state of cautiousness among investors. 

Source : TradingView, chart prepared by author

Volatility skew inching higher

SPY 25delta put-call skew

A rising put-call skew indicates relative demand for protection on the downside. Here the skew has been inching higher since late May and has consistently stayed above the 20-day average, though in the last few days the skew has come off a bit. 

CBOE SKEW Index is a measure of 2/3 sigma (defined by CBOE as 'tail risk') move in the S&P 500, and that has been inching higher since Mar 18th 2020. In the last couple of years, it's been observed that a higher skew has been associated with substantial market declines (as in the chart below) - notably the crashes of Q4 2018 and the Q1 2020.

Source : TradingView

Implied Volatility (IV) smile comparison across expiries

Another way of visualizing skew (or the slope of the IV curve) is to look at the IV smiles for the upcoming expirations in Jul 2020, which are progressively steeper down the expiries, indicating elevated risk off sentiment. Under normal market scenario, IV curves flatten out as we move down the expiries. In the chart below, we are almost seeing an opposite behaviour. 

Source: MarketChameleon

VVIX ready for a spike?

VVIX is forming a classic bull flag which is something I will be keeping a close watch on. Normally VVIX spikes are followed by spikes in VIX. 

Source: TradingView

In summary, as I see it, volatility indicators defy the recent rally in the S&P 500 as investors continue to bid on downside protection. This is not to say that the equity market cannot rally further, but keeping a watch on the volatility seems prudent to actively manage the risk positions.