ALARM!!(NOT!)… VIX Light Inside

Hey Traders,

The S&P 500 was up just under 1% on Monday.

The VIX was up slightly as well …  

This would sound the alarms, as one of the pieces of our volatility trading system is how the VIX is correlating to the S&P 500.

The VIX, because of the way volatility is calculated versus days-to-expiration, has a funny hitch in it that will cause it to be up on Mondays. (All things being equal, by about .80; it’s related to option decay being constant and trading days being INconstant.)

Coming off of a 3½ day weekend, I would have been looking for the VIX to be up roughly 1.3-1.5 points (because, again, option decay is constant and trading days are not).

So the VIX price action was pretty normal.

The same cannot be said for the VIX futures curve … It has a massive contango between cash and Jan. (This means that the cash index is trading at a pretty big discount to the January future.)

The January future is also trading at a big discount to the February future.

Then …

Everything goes flat.

The discount between cash and Jan can probably be explained by the Georgia Senate runoff elections.

The direction of the Senate and whether  Democrats have complete control of the US Government is certainly a volatility event, as it would affect:

  • Taxes
  • The budget
  • Congressional review of Biden administration regulations

A whole host of events!

It’s the flatness that is strange.

Generally speaking, a flat curve tends to be bearish.

HOWEVER … I want to make a different case:

Contango happens because the market is more afraid of the long term than what is directly in front of it.

The back end of the curve is predicting the VIX falling, it’s just not sure when.

This chart shows the VIX curve from last year:

Notice the general upsloping curve. This is because markets are fearful of the long-term unknown. (Turns out, they had good reason.)

The current VIX formation is not something I can remember seeing. Here is what I THINK it is though:

The market expects the VIX to drop …

… it’s just not sure when.

The back end of this curve, is a whole strip of bets that sometime between February and September the VIX is going to drop.

At that point the entire front end of the above curve will swing lower.

This will be very bad for VXZ which is long a strip of futures between months 4 and 7.

In the meantime, the spread between cash-Janurary and January-February is going to put a TON of pressure on VXX and UVXY.

It also makes for some very interesting bearish VIX plays.

One trade I think is interesting is long the 22-19 put spread for 1.30.

The VIX light is RED, meaning our proprietary indicator believes the VIX is likely to drop over the next few weeks.

Your Only Option,

Mark Sebastian

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