What the volatility futures it’s roll over is hinting on market’s view

Since 2008, anyone who’s observant knows once VIX – the weighted average implied volatility for SP500 well diversified components based on CBOE model and calculations – exceeds 20, it hints at market fear of Financial market correction or correlation breakdown, where both correlation and volatility spikes. 20 means the expected daily market movement for the next 5 days is 20%/sqrt(252) where volatility scales directly to the square root of time.

However, VIX index has futures contracts for the next subsequent 8 months and a rolling generic front and consecutive months contracts are available at quandl. This allows us to have a view of how fearful the market is pricing in for the next few months ahead. As of now, futures are all higher than earlier contracts and spot. Such a contango scenario implies that one who’s portfolio exposure is skewed to a directional long is able to do a stacked and roll hedge on its “risk off”, or in another words, short volatility exposure by holding a stack of long VIX front contracts and rolling over  into VIX futures from the next most front contract. Roll over cost is positive only if it’s in a contango scenario, which is true as of now. In the opposite end, a backwardation scenario where spot is priced higher than futures or market expects a higher risk premium on the front end of the curve implies a negative roll over cost and hence market is “risk on” and unable to hedge against its directional long exposure. We see that on SPX VIX futures spread where there is a divergence between cost of carry and direction of SPX. Across regions beyond U.S., this divergence is seen in EUREX STOXX 50 as well. This is a sign of market faltering to weakness and hence I am rotating into defensive sectors. This reason is also established in my previous post. Looking at the Europe elections at May, European market is pricing in a spike in volatility from 18% annually to 22% annually in April-May 17. VIX term structure might have gotten a parallel shift across all maturities because of a higher risk free rate, but a tilt in specific month contracts implies an additional risk premium above that of risk free rate. In conclusion, I recommend a shift to sustainable value stocks with organic growth in earnings revision rather than on momentum strategy as of now, as the market is showing signs of faltering after weeks of rally.

EUREX VSTOXX 50 Term Structurets1Source: quandl,python

Important election dates in Europe for 2017

U.K. local elections

May 4

So what: Local ballots across the U.K. will provide the first major electoral test for new Conservative Prime Minister Theresa May as she seeks to steer the country toward an “orderly” Brexit while limiting damage to the economy.

Outlook: Polls have shown the Tories taking a lead of as much as 16 percentage points over the opposition Labour Party, currently distracted by a leadership contest. The elections in Scotland will gauge support for First Minister Nicola Sturgeon’s Scottish National Party, which is considering calling a second referendum on independence.

German regional elections
Schleswig-Holstein and North-Rhine Westphalia

May 7 and 14

So what: Should the Social Democrats lose to Angela Merkel’s Christian Democratic Union in their traditional stronghold of North Rhine-Westphalia, Germany’s most-populous state, the CDU could get a boost heading into the September’s parliamentary elections.

SPX VIX Term Structurets2.pngSource: quandl,python

EUREX VSTOXX 50 Futures Spreadeurex1 Source: quandl,python

SPX VIX Futures Spread

Source: quandl,python

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s