VIX Can Be Deceiving as Steep Curve Shows Uncertainty: Analysis

The slope matters more than the level

Don’t let the low U.S. equity volatility fool you. The increasingly steep term structure of Chicago Board Options Exchange Volatility Index, or VIX, futures shows uncertainty remains high amid weak global growth and rising concerns about effectiveness of central bank policies, Bloomberg strategist Tanvir Sandhu writes.

The VIX futures curve’s typical contango, where the term structure is upward sloping, means roll-down costs will erode any returns from outright long positions or even cause losses.

In an era of high hedge-fund redemptions, central bank-induced price distortions, algorithmic trading and regulatory risks, the stock market is susceptible to large flash crash-type selloffs that would bring so-called convexity of volatility into focus. In a convex relationship, volatility accelerates as equity declines.

VIX curve contango

The contango in the VIX curve implies negative roll-down costs on long positions, which can cause net losses even when directional view on volatility is accurate. With current VIX spot trading at 15 and the June VIX future at 18.5, a 3.5-point loss would be suffered on roll-down, assuming no change.

As the front-end VIX futures curve has steepened, increasing roll cost, the VIX Short-Term Futures Index shows falling returns from daily rolling. That compares with a modest steepening of the mid-term VIX futures curve, adding to roll cost.

The difference between spot VIX, which tracks expectations for future stock swings, and one-month historical volatility in the S&P 500 index is now 6 points, compared with an average of 3 over the past 10 years. As VIX measures the market expectation for the actual one-month U.S. stock volatility, the wider spread can weigh on the roll-down.

Convexity of volatility

Local shocks are likely to persist in a low global-growth environment while risks of aggressive selloffs remain amid increasing questioning of the effectiveness of central bank policy, as shown in inflation forward curves.

Concerns about potential volatility spikes and VIX roll-down costs can bring into focus convexity options, which are particularly favorable in aggressive selloffs that accelerate VIX gains due to the asymmetry of equity volatility. S&P 500 put options currently have a high premium owing to the steep volatility skew.

Note: Tanvir Sandhu is a cross-asset derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.

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