Monday, August 10, 2009

VIX, the past and the future

The headline from Bloomberg this morning is "VIX Signals S&P 500 Swoon as September Approaches". What does that mean? It's worth taking a quick look at VIX, the story of it's past, and the story the futures curve is trying to tell us. For those who are interested in how CBOE computes the index and it's various applications, please see the document below from CBOE.

First, the history. As a measure of implied volatility in the S&P500, VIX is a powerful indicator of the level of fear in the system. It's a relative measure of where the Street prices risk. It has the same characteristics as credit spreads, but is more transparent and real-time than say CDS spreads. Let's take a look at the chart of VIX history from the beginning of the crisis. Again, most people think the financial crisis is an 08 event, but it actually started in early 07 as the first signs of sub-prime accelerating delinquencies showed up. VIX signaled that risk fairly early, stayed at slightly elevated levels spiking in early 08 with Bear, and finally exploding in the Fall of 08.

VIX


VIX continues to be at elevated levels relative to it's history, but it has collapsed relative to it's highs last year (it's now back to just post-Bear Stearns levels). One of the most painful features of being long volatility is theta (time decay), that can produce gradual yet painful losses. Many traders who do not see a catalyst for a selloff or increased volatility would rather not hold long volatility positions (unless they are hedging something else in the portfolio).

In spite of the massive VIX correction from the peak, the futures are telling us something else. Even though the overall levels have come off significantly, the VIX futures curve has steepened considerably. That means people are willing to pay considerable time decay as futures roll down the steeper curve to be long. And they want to be long specifically September/October maturities, with the curve coming off in later months. The Street is bracing for a selloff in equities this this Fall.



Interestingly, this "bump" in the futures curve has existed for a while. It has shifted forward and became more pronounced as the market rallies. The curve kept saying "the selloff is just around the corner". Ironically (at least in part) it may be that belief in the certainty of a impending selloff that has kept the market so buoyant.




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