The SPY is pretty much at all-time-highs (what's new), and everything is good right? I would beg to differ. Depending on which volatility market you examine, some are pricing in a market pullback, some are suggesting times have never been better to invest. I firmly believe that the most likely outcome of the two sides is more leaned towards that of a drawdown within the S&P 500 index. In this post, I will show which volatility markets are bullish, which are bearish, and which I believe is the more correct of the two.
Update on the VIX and VVIX
In my previous posts, I have spoken multiple times on the VVIX and the VIX, as they are extremely important measures in gauging how the market might preform in the future on a 30 day basis. The end of this trading week further reiterated my previous view on how there was an ever-expanding VVIX and VIX divergence. This week, the VIX closed down roughly -6% from Monday's reading of 21.24 to this Friday's close of 19.97, while the VVIX rose from 106.61 to 118.59, a gain of +11.23%, while the SPY only rose +0.05% this week. Obviously, with such a measly gain from the broader market with a significant rise in vol-of-vol risk within the next 30 days, there further extends the assumption that the underlying concerns on such an index are growing. Risk is rising under the hood of the SPY.
Which Volatility Market is Right?
With such an obvious divergence in two different implied volatility indices, it might be time to "pick and choose" which one to follow. Personally, I would follow the VVIX due to its underlying construction of how it front-runs the front-running volatility measures on the S&P 500 index. Also, I believe that the implied volatility futures market is fundamentally mispricing a sudden shock to the system. I will elaborate on this idea below.
The chart above is the VXX, the VIX Short Term Volatility Index. This ETN essentially takes the weighted average of the front month futures contracts to create a 30 day forward spot price. What this chart shows that it is within the lowest levels since the start of the COVID-19 market crash, showing a significant decline in price since its highs in March. So, knowing that the VXX is supposed to track VIX futures, allow me to show you actual prices of VIX futures.
What is extremely interesting is that the VIX futures are naturally in contango, which is to be expected in "normal" market conditions where forward looking implied volatility futures on the VIX index are higher than the spot price of the VIX for varying expirations (they have premiums attached. So, if one were to bet on a rise in expected volatility, you would have to get your move, and then some more to break even from the initial premium from your trade. So, now that we clearly see VIX futures are above the VIX index, and the VXX by construction should be higher than the VIX index (which is clearly not the case), I believe that there presents a potential trade opportunity. There is a discount from what the VXX theoretically "should" be from where it actually is, based on what it tracks. This divergence from its intrinsic value and its spot value is most likely driven by speculative behaviors by market participants, A.K.A. "emotions and biases" are at play. An additional reason why the VXX index is below the spot front month VIX futures contracts would be due to the fact that the fund manager of the VXX ETN has to continuously roll their contracts forward in order to create an instrument that represents the closest number to 30 days as possible. Investopedia puts forth a very simple elaboration of this roll effect on shares of the VXX: "Since VXX must roll its futures contracts to rebalance the fund to the later contract, the fund manager is forced to sell the futures contracts that are closest to their expiration dates and buy the next dated contracts, which is a process called rolling. Since longer-dated futures contracts are often at higher levels than shorter-dated ones (during normal market conditions), the rolling activity can result in losses (as the ETN is forced to sell the lower valued contracts and buy the higher-priced contracts).". So, this constant rebalancing put forth by this ETN clearly negatively effects its spot value from its theoretical value. A clear representation of how "off" this ETN is from its intrinsic value can be seen from the VXX.ID index, which is essentially what the VXX aspires to be (not actively traded, no expense ratio, no negative costs associated from rolling futures contacts, etc.).
A clear observation is that this VXX.ID index is clearly elevated (in most circumstances) above the VXX ETN. So, seeing how this front-month futures index has its spot value of 27.24, and the VXX ETN is at 15.74, this represents a -57.8% discount from what the intrinsic value of this ETN should theoretically be. At face value, this can seem like an extremely favorable trading opportunity. However, there are a couple important things to consider. For instance, pre-COVID lows for the VXX and VXX.ID were 13.15 and 22.46, and during-COVID highs were 78.84 and 135.36, respectively. The discounting the VXX's value at low was-58.55% and at high was -58.24%. So, this divergence in spot values from what the VXX "should" be and what its spot value is constant, and therefore does not represent a tradable opportunity. Furthermore, this extreme discount in price is mainly the result of the costs associated with rolling forward futures contacts. The below chart is a visual representation of how closely these two products track each other, only producing a deviation of more than 4% in the heights of the most recent market crash, an extremely impressive feat (props to you, VXX fund manager).
Which Volatility Market is Right?
Well, this is an extremely difficult question to answer, as this is the essential question to nearly all question regarding the trading and risk management of volatility products. In my opinion, I believe the VVIX index is the more correct index, while the VXX, VXX.ID, and VIX products are merely displaying the mispricing amongst the volatility asset class with respect to each other. In essence, the VVX, VVX.ID, and VIX index have declined -37.07%, -37.02%, and -37.07%, respectively, since VIX lows on October 1, 2020, while the VVIX has appreciated by +14.83% (all numbers of the same time period). This clear divergence in equity volatility markets (or, more specifically, the S&P 500 index) represents a trading opportunity, as it is mispricings and market disagreements like these that create opportunities for arbitrage-like strategies. As the VVIX is the more forward-looking instrument of all listed, as well as how it takes into account different implied volatility risk factors that the traditional VIX index does not employ (explained more thoroughly in previous blog post), its current values represent more information on the volatility space, and therefore allows for the trader to anticipate changes in regime for implied volatility more proactively than simply using the VIX or VXX. Implied volatility futures markets on the S&P 500 are not in agreement with the implied vol-of-vol instrument of that same underlying index.
Update on Dealer Positioning Within the ES Markets
Oh, and one more quick thing. Dealer positioning (A.K.A. market maker's positioning) has remained strictly net short from when I last mentioned dealer positioning on 2/2/2021, with the overall net short positioning essentially the same as before (-67.18% vs -67.26%). This extremely marginal difference could be potentially accounted for by the increased number of spreading positions being taken on by ES dealers, increasing by +18.87% from 2/2/2021. Overall, market makers on the ES futures contracts are net short, and more than likely to remain net short.
Conclusion
In summary, the difference in pricing implied volatility risk on various markets creates some interesting pieces of information, as I interpret it as more bearish than bullish. Dealer positioning continues to anticipate a drawdown in the S&P 500 index within the ES futures contracts market. Also, I understand the title is "Futures Market or Option Market, Who is Right?" is somewhat incorrect, as futures on the VIX are a derivative of the options market within the S&P 500. However, just thing of it as isolated markets to make things less confusing. Furthermore, let's get this bread.
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