In my previous article, I played with the idea of a vol spike in the markets, more specifically, the S&P 500 option markets. This idea still holds with me, as today's action has not really changed much. I will give specifics on what happened today (from a volatility standpoint, of course), and how this can effect the future returns of the SPX.
Breadth Update
This morning, the SPY (a SPDR ETF-Tracking security for the SPX) opened up at 389.27 and closed at 390.51 for a gain of +0.72%, reiterating the all-time-high events that have been taking place. Although great news, I still have concerns. In my previous post, I mentioned how volume was down -33.66%, -31.71%, and -26.45% against the 5 day, 15 day, and 30 day previous volume averages, respectively. Now, these numbers have gotten worse, with the 5 day, 15 day, and 30 day at -33.33%, -45.91%, and -41.84% respectively. Also, just for a fun fact, this trading day's volume is down -20.89% versus the prior day. My interpretation of this data is that there is a diminishing number of buyers at these current levels, further allowing the possibility of a "healthy" pullback towards lower levels.
Volatility Update
I cannot stress enough how important analyzing the security's volatility complex underneath the surface area of price is. There have been numerous academic papers that cite the advantages that volatility timing, rather than traditional market timing, is far more advantageous in timing markets. Hence my strict focus on volatility and it various characteristics. With the SPY moving upwards by +0.72%, its underlying volatility complex, the VIX, appreciated in spot value by +1.77% to a level of 21.24. This is extremely important, as I previously wrote a blog piece of a very similar setup that occurred with Apple a while ago. When a security's value appreciates (marginally, in this case), volume is rapidly diminishing on these bullish days, and its underlying volatility characteristics are disproportionately increasing, this can certainly beg a problem that can brew under the hood. You want the opposite to occur, with volume supporting the move higher, and its underlying volatility complex diminishing. This is clearly not the case.
Another important piece to note is how the VXX acted as of today. The VXX tracks futures products on the VIX, creating a weighted average of VIX front month futures products to get a duration value of 30 (since there might be a VIX future with a time-to-expiration of 28 days, and another with TTE of 32, it will create a weighted average of the two futures values to get a duration value of 30). Now, it is important to note that, under normal market conditions, the VIX futures are usually in what is called 'contango'. This means that VIX futures products are at values that are above the current VIX index level. So, naturally, small moves in options implied volatility within the S&P 500 index do not necessarily create a trading opportunity. It is the anticipation of larger moves that would cause these VIX futures contracts to rise substantially enough in value to provide a real trade. So, when the VIX moved up by +1.77% today, VXX actually fell in value by -0.85%. Weird, right? However, this makes sense because if you are already paying a premium in normal market conditions (which we are 'kind of' experiencing at this point in time), underlying volatility will have to move a substantial amount for you to even break even on the trade. Now, an important mechanic of futures contracts is how they must converge to the spot price of the underlying instrument (in this case, the VIX spot price). So, if you believe that there will be a significant spike in volatility within the near term, it can be reasonable to put on such a trade.
So, if VIX futures markets do not entirely believe in the future of implied volatility of the S&P 500 derivatives markets, yet options markets are pricing in such case (marginally, but nonetheless true), who might be wrong here? The answer is: both. VIX futures (as of this moment in time) by using the VXX are actually up +0.61% as of most recent close (from 16.33 to 16.43 for the VVX product). So, VIX futures markets are actually beginning to price in some levels of volatility in the future through extended hours trading, following the beginning trend of the VIX. There is clearly a bid for volatility products.
An important note is how the VVIX (which I cited in the previous blog post as the vol-of-vol index) actually declined in value today by -0.96% to a value of 106.61. This is a small number and is not entirely too significant because, if there was a true breakdown in implied vol-of-implied vol, then this index would shoot downwards and subsequently gap to significantly lower levels, since it is a more volatility product by construction. My only concern here would be if VVIX broke down from its current trend of producing higher lows, which it has not so far. If vol-of-vol did break down, then I would strongly consider the possibility of a tighter return distribution of the S&P 500 in the future that would be subsequently priced in through derivative markets.
Conclusion
In summary, the continued bullish action today did not deter my original standpoint in my previous blog post that the market as a whole is underpricing a significant and rapid drawdown in the S&P 500. VIX futures markets are slowly beginning to price in implied volatility, but there is no obvious answer to when these events can take place.
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