Will the VIX Ever Go Up Again?

Although it is early in the month and a lot can change between now and the 31st, October is on pace to be the least volatile month ever in the S&P. Not surprisingly, the lack of volatility has sucked the life out of the Chicago Board of Options Exchange's (CBOE) volatility index, known simply as the VIX. Likewise, those attempting to go long volatility with inefficient ETF derivatives of the VIX have likely suffered surprisingly painful losses.

Even the purest method of VIX speculation, which in my opinion is the futures version, comes with baggage; but the ETF versions amplify the baggage into an outright anchor. Nevertheless, VIX speculation is a potentially high-reward prospect in which traders are willing to take their chances.

The Problem With Volatility ETFs

Not unlike commodity ETFs, volatility ETFs are simply exchange-traded funds in which investor money is pooled to "invest" in the corresponding futures contract. In this case, the underlying futures contract is the VIX future traded on the CBOE (this happens to be the one and only futures contract traded on the exchange). Volatility funds generally spread the invested capital to several contract months (remember, futures contracts expire) with much of the allocation often being in distant months. Those who are familiar with the commodity markets know that this leaves the fund exposed to a substantial amount of contango. This is particularly true in the VIX futures markets.

If you aren't familiar with the word contango, it describes the relationship between the cash market and the front-month futures market pricing and, more importantly, the pricing of each expiring futures contract relative to the subsequently expiring futures contract. This sounds a lot more complicated than it really is.

To clarify, let's look at an example of contango in the VIX futures market. At the time this column was being written, the CBOE quoted the cash market (spot price) VIX at 9.65. However, the next expiring futures contract was the October VIX, which was trading at 9.95. Similarly, the November, December and January futures contracts were trading at 12.50, 13.15 and 14.30 respectively. As you can see, the price of each VIX futures contract moves higher as the expiration date becomes more distant; this is contango.

Contango can be extremely expensive for those wishing to hold a long-term position in the VIX futures market, which generally isn't a great strategy. For instance, a trader who purchases a November futures contract at 12.50 will lose roughly three points, or 2.85 points if you are a stickler for specifics (12.50 - 9.65) if held to expiration and volatility as measured by the spot VIX doesn't change. In short, the futures price and the spot price must come together at the expiration of the futures contract. All else being equal, the only way for this to occur is for the futures contract to erode into expiration to match the spot price, or for volatility to move substantially higher, forcing the cash market to meet the futures price. Further, even if the spot VIX moves up by nearly three points, the futures trader could be merely breaking even due to contango erosion. If you think this sounds bad, try experiencing it as an ETF trader; the obstacle is tenfold -- not to mention, administrative fees for fund managers.

The bottom line is, trading in the VIX isn't for everyone, but if you are going to do it the most efficient venue is likely the futures markets. Yet it is imperative that traders without experience and a basic understanding of how futures markets work consult with a professional before proceeding.

The Problem With VIX Futures

The aforementioned frustration of position erosion in the absence of volatility might sound familiar to anyone who has purchased an option and watched the value slowly dwindle away. This is not a coincidence; the VIX is an index based on the built-in implied volatility (expectations of future volatility) in the S&P option market. Thus, in some ways being long, the VIX is similar to being long S&P puts.

In agricultural commodities such as corn or soybeans, contango exists to account for the storage costs of grain between now and the expiration date of any particular futures contract. In the VIX, contango exists because the market generally expects volatility to increase as the time to expiration increases. In essence, the longer the time to expiration, the greater the odds of volatility occurring. Thus, the market prices in higher VIX levels for distant expiration months.

Because of contango, traders should try to keep VIX speculations brief. Holding a VIX futures contract for the long haul has the potential to become very painful. In my opinion, the best trades in this particular market are left for the VIX bulls with the patience to wait for extreme lows and the foresight to avoid overstaying their welcome. The VIX has a tendency to trickle lower but it generally takes the elevator higher; this is inverse to the characteristics of the S&P itself. Yet the VIX can also erode quickly after a large spike higher.

In conclusion, the VIX mirrors the emotions of market participants. As humans, we are prone to irrational and dramatic shifts between fear and greed; and, thus, so is the VIX.

VIX Futures Chart

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VIX Futures Chart

Both market volatility and investor complacency are at, or near, all-time-highs. Historically, these types of environments have been extremely comfortable in the moment but have had a strong tendency to become uncomfortable in the blink of an eye. In fact, extreme cases such as the market tops in 2007 and 2000 were on the heels of a landscape similar to the current one. I am not of the belief we will get a repeat of those calamities, but it is certainly worth noting that the odds are the existing sense of calm likely won't last much longer.

The daily VIX futures chart above suggests prices are sitting on trendline support. Further, technical oscillators suggest that the downside is likely limited from here. Even if a trend reversal isn't in the cards, we should at least see some sort of temporary resurgence in volatility. The MACD (Moving Average Convergence Divergence) indicator is as oversold as we've ever seen in the VIX, or nearly any other market for that matter.

Although the risks are high, this is arguably one of the best times in history to be a volatility bull. On the flip side, long-term stock-market bulls should probably take this time to reduce risk and lock in gains. 

At the time of publication, Garner was long October VIX futures, although positions may change at any time. There is a substantial risk of loss in trading commodity futures, options, ETFs. Seasonal tendencies are already priced into market values.