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VIX is not Just for Kicks
One of the best ways to measure market volatility is the VIX index, which basically is an expression of the demand for puts and calls on the SPX 500 index. Some will define it other ways but simply put that is the crudest and most raw definition – and really suits our purposes here. When the VIX is on the rise so is fear and put buying is rampant, protecting portfolios in the event of some individual selling, institutional distribution or some future negative event. A rising VIX implies elevated option values, that protection becomes expensive to purchase. Likewise, a falling or low VIX implies cheaper option premium and a willingness to hold positions – it displays confidence in taking on risk.
What we describe above is simply the VIX cash, which represents a 30 day future value (expectation) of market volatility. Traders also have the liberty of using the VIX futures to trade or hedge positions. Now, the VIX futures curve, or term structure is shaped like a any commodity or future. Conditions are defined as contango or backwardation (more on those at another time). An upward sloping curve (in contango) means a healthy volatility curve, and when there is excess premium at each time period it’s even better (see picture). Traders are willing to pay more for volatility out in time – normal. When the VIX curve is in backwardation the opposite is true and we often see a bear market condition.
So, recently (last week) we saw the VIX cash jump over six future strikes (see picture below). Monday it corrected some but not enough, and I suspect unless something ‘really’ changes then we’ll see this curve back into contango within a couple of days. Nothing much has changed other than a market undergoing a modest correction. But even during a correction we see players reaching (over-reaching?) for protection, especially coming off a year like 2013. It makes sense, doesn’t it? So, if the market can swing higher on Tuesday we’ll see the curve back to normal – and just in time with some heavy news to hit the ‘street (Fed, earnings, GDP, other big economic data, end of January).
As I mentioned in this article about premium selling this week, we can all take advantage of these high volatility spike but understanding the conditions and the situation, learning the movements and rhythm of markets and tactically placing our bets that give us the best odds of success.