The VIX Curve Starts to Pay Attention

Articles From: Interactive Brokers
Website: Interactive Brokers

By:

Chief Strategist

Interactive Brokers

Today is 2022’s three-week birthday.  So far, for better or worse, our 2022 outlook is looking prescient:

The primary theme is for investors to expect more volatility than we’ve seen over the past year-and-a-half.

Despite the eye-catching moves we have seen over the past few weeks, including yesterday’s 2.5% reversal in the S&P 500 Index (SPX) and over 3% reversal in the NASDAQ 100 (NDX), the market’s “fear gauge” has been slow to catch up.  Those of you who have followed my work are likely well aware of my view that the CBOE Volatility Index (VIX) is not constructed as a fear gauge – it’s meant to measure the market’s best estimate of volatility over the next 30 days – but VIX’s tendency to inversely correlate with SPX allows market observers to interpret movements in VIX as reflecting traders’ nervousness.

I prefer not to view the level of VIX in isolation, but instead to analyze spot VIX (the level of the index that is commonly quoted) versus VIX futures.  Think of this this way, does it matter much if VIX is 18, 20, or 23?  Without context, that level is difficult to interpret.  It is much more useful to look at VIX in conjunction with where traders see volatility in the future.  Consider the chart below:

VIX Futures Curves, Today (green), Yesterday (orange), 2 Days Ago (red), Last week (blue)

VIX Futures Curves, Today (green), Yesterday (orange), 2 Days Ago (red), Last week (blue)

Source: Bloomberg

As recently as a week ago, even as markets were starting to display increasing volatility, we saw spot VIX below 20.  But more importantly we saw a relatively steep curve sloping up and to the right.  In futures markets this is called “contango”, and is the normal state of affairs if the commodity in question (in this case volatility) is in plentiful supply.  Simply put, traders were not clamoring for volatility protection even as markets had become more volatile.  This is something we first noted two weeks ago, noting that:

Until or unless we see VIX futures either rise to those levels we saw last month, or we see an inversion in the futures curve, it is too early to say that investors are truly nervous.

Well, they’re a bit more nervous now.  Notice that in the graph above, spot VIX exceeds the level of all the subsequent futures.  When futures are higher in the front months than in the back, it is called “backwardation” and implies a relative scarcity of the commodity at present.  It is clear that traders have begun to clamor for protection.

That said, the curve is still in contango from the first future on.  Truly panicky markets show backwardation throughout the whole curve.  We are seeing mild nervousness – it’s hard to imagine that investors remain truly sanguine after what we’ve seen in this short week (in the US) and in the year thus far – but they’re not freaking out either.  Today’s bounce off the SPX 200-day moving average shows that many traders are still utilizing traditional support levels to either cover shorts or as an entry point for longs. 

This is a time for investors to show discipline.  The market’s psychology may be changing after one of the greatest risk-on periods in history.  Changing times demand changing tactics, as we noted earlier this week.  And if the recent volatility spooked you, it is a sign that you have exceeded your risk tolerance.

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