Everyone ran for the door today, and protection that was insanely cheap just a couple days ago is now soaring in price. The market is clearly confused, and VIX derivatives are priced inversely to their normal relationship to spot VIX.
The VIX term structure represents the VIX S&P 500 weighted implied volatility over points in time. This is how it reacted to today’s sell-off:
Backwardation is rare, and often signals additional pain in the equities markets. The VIX futures are priced lower than spot VIX and lower than the term structure:
| VX H3-CF | S&P 500 VOLATILITY | March2013 | 16:15:00 | 17.60 | 2.75 | 14.55 | 17.70 | 14.10 |
| VX J3-CF | S&P 500 VOLATILITY | April2013 | 16:15:00 | 17.50 | 1.80 | 15.35 | 17.62 | 15.02 |
| VX K3-CF | S&P 500 VOLATILITY | May2013 | 16:15:00 | 17.50 | 1.05 | 16.05 | 17.80 | 15.84 |
| VX M3-CF | S&P 500 VOLATILITY | June2013 | 16:15:00 | 17.95 | 0.95 | 16.65 | 18.05 | 16.42 |
| VX N3-CF | S&P 500 VOLATILITY | July2013 | 16:15:00 | 18.30 | 0.60 | 17.35 | 18.50 | 17.10 |
The VIX futures are almost in backwardation as well. What this means to the VXX, is that if the VIX continues higher, the VXX actually has ground to make up to reach spot. At this point, the VIX futures are implying that volatility is going to decrease in the near term. Furthermore, the VIX futures roll yield is now flat, and if backwardation occurs, the VXX will have a positive roll. In extreme sell-offs, this positive roll is a big kicker for VXX holders.
What does this mean? Clearly, markets were due for some kind of corrective action. The problem with preparing for days like these is that there are no obvious signals, therefore you have to be thinking way ahead of the crowd to get the best prices, and thus the best return on volatility. The algo/black box driven markets erase month/s of gains in one or a few days.
You have to embrace times like these, where on the one hand you get historically low volatility, then days later you set a high for the year. On the XHB, you could have purchased $26 puts for .12 this morning that are now worth .34. Pick your favorite highly liquid ETF, XLF, IWM, etc. The March puts on these saw massive moves today, and would have cost you very little.
The game plan now is to look in the other direction. The last time VIX was this high on Dec. 31, volatility imploded shortly after, and VXX puts paid of in the hundreds of percent. Today we started with April $19 VXX puts for .28-.35, and a few March VIX $13 puts for .10. Any sort of resolution in D.C., or change in market direction, and these will pay handsomely. If the VXX goes higher, and we expect volatility for an extended period, we will look farther out, even toward the Jan 2014 puts. Last year well timed LEAP puts paid 400+% on the VXX.
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