Even Calmer Waters Ahead for the VIX?

by Tyler Craig | August 27, 2012 9:25 am

Despite the tendency of the financial market punditry at large to use the CBOE S&P 500 Volatility Index (VIX) as the authoritative gauge for implied volatility, it fails to capture market expectations beyond a 30-day window. Fortunately, volatility junkies have a variety of VIX futures contracts available that provide a more comprehensive view of volatility expectations over multiple months to come.

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A popular approach for analyzing the different durations of VIX futures contracts is to view a term structure chart, which plots the current value of the VIX futures contracts over time. Connecting the values of these contracts in sequence creates a curve that reveals whether the VIX Index is expected to rise or fall as time passes. If the curve is upward sloping, as shown in the accompanying chart, the futures are said to be trading in “contango.” If the curve is downward sloping, the futures are in “backwardation.”

Right now, VIX futures find themselves firmly footed in contango territory, reflecting market expectations that the VIX will rise from its current lull at some point down the road. But, of course, such a forecast is a no-brainer given the VIX Index is a mean-reverting animal, always returning to its long-term mean of 20. While its eventual destination is all but assured, the path it will travel and the length of its journey remain a riddle wrapped in an enigma. Maybe we hit 20 in a week, maybe the reunion is delayed for months on end. It all depends on how long the ongoing bullish fever lasts.

Those who believe the current low-volatility regime will continue to reign for the foreseeable future might consider bearish plays on the iPath S&P 500 VIX Short Term Futures (NYSE:VXX[1]). Provided the VIX Index remains in the mid-teens, VIX futures really have nowhere to go but down. In addition, the hefty $2.65 premium that October futures have over September will also act as a stumbling block to any attempt of VXX to muster a sustained advance.

Traders could enter an Oct 12-10 bear put spread by buying the Oct 12 put and selling the Oct 10 put for a net debit of $1.20. If VXX falls to $10 by October expiration, the call spread could generate an $80 profit — or a 66% return on investment.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

  1. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX

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