For several weeks now in our Volatility Tracker we’ve noted the persistence of a premium in longer-dated VIX futures versus the front-month contract and especially the spot VIX. Historically, divergences like these have resolved in favor of the futures price rather than the spot VIX price, which has tended to correlate with a decline in the S&P 500.
Clearly, those tendencies haven’t held up in this case. The market has rallied relentlessly, VIX has continued its steady decline, and the relative premium in long-dated implied volatility has persisted even as it also declines in absolute terms. In other words, one might think of the spot VIX acting like a magnet, pulling down on the higher futures.
This somewhat unusual inversion of the relationship between spot VIX and the VIX futures helps explain the downward slope of the term structure, and seems to confirm the strength of the recent rally. Even so, notice that the expectation remains for an increase in implied volatility this fall: October futures, currently just shy of 30, are still above even the long-term consensus “floor” around 28. As Larry McMillan remarks in a recent note:
Obviously, the S&P 500 Index option traders are seemingly reluctant to sell volatility for what they perceive could be a highly volatile market in the fall of this year. Conversely S&P 500 Index option buyers of those expiration months are seemingly willing to pay up for the options. This is what may be holding VIX futures prices up, even though VIX is low, and historical volatility of the S&P 500 Index is low. Are these option traders going to be correct? We do not know for sure, but it seems to be a consensus being placed by a lot of option traders.
Now, even if you think the options market will be proven right later this year, this doesn’t present a tradeable edge in itself. After all, the reason those VIX futures remain higher is that traders are willing to pay for November and December SPX options at a higher implied volatility – so any portfolio insurance purchased now will already have this information priced in. It’s also worth mentioning that, all things considered, even a five point increase in implied index volatility isn’t necessarily a reason to buy a lot of protection: with a VIX at 25, we can expect the S&P 500 to trade up or down 1.5% each day about 68% of the time; at a VIX of 30, that percentage is closer to 1.9%. So, at current levels, we’re talking at most about a more exciting autumn, not a return to “Lehman levels” of volatility.