Trading Update for January 17, 2018

Volatility is back! A very unusual day developed today as every major index opened at fresh all time highs then retreated after the first half hour. VIX also opened higher in the overnight session and continued rising all morning, peaking at 12.41 this afternoon.

S&P Futures initially rose today and peaked by 10am ET. 5min bars.

Usually VIX drops when SPX rises, but the first half hour of trading today saw the VIX rise despite SPX reaching new highs. This should ring alarm bells for any volatility trader. What is going on and how do we expect volatility to resolve this?

VIX also rose this morning and even dropped with SPX before decoupling. 5min bars.

Occasionally we can see a rising VIX together with a rising market as a technical response – traders buying insurance in the form of SPX puts as the market adjusts higher. This can be normal and is usually transient, lasting a few hours to days. VIX can also rise if there are news events triggering volatility. Today's action may be a result of both of these forces. The SPX just finished its fastest 100-point climb in history, increasing concern among traders for a sudden drop. Meanwhile politicians are on the brink of a US government shutdown, the nature of which could indicate how future debates such as infrastructure spending might play out in congress later this year.

A volatility trader must ask themselves though, with markets at an all time high and VIX already 18% off its low, what market conditions could possibly move VIX now? Would the market surge even further, thereby relaxing the VIX? It seemed unlikely with how far markets have moved this month. Would the market cool off and trade sideways for a while? This was certainly possible, but VIX probably also wouldn't drop back to 9 in this scenario. Would the market drop and retest some recent levels? This seemed long overdue, and in this scenario VIX would have to keep rising.

We finally saw the third scenario play out today. SPX traded across the previous day's entire range, then closed off its lows. VIX likewise surged to 12.41 and reversed as SPX made its low for the day.

Now the question becomes what “what happens next?” Of course, nobody knows for sure, there are only probabilities. So let's look at some indicators:

VIX chart, 2018 YTD. Notice the drop in contango, rising VXST:VIX and falling futures premiums.

VXST/VIX has been rising for the last two days and reversed just after touching 1.0 today. This could be favorable for a short volatility position in the short term. It also would have provided an excellent first entry into a short volatility trade.

Contango between February and March VIX Contracts, on the other hand, has been decreasing for a while, although it recovered near the end of the day today. Still, contango of 5.6% is modest and not the usual benefit to SVXY/XIV and less of a drag on UVXY/TVIX/VXX. This is a mixed picture. I usually like to see contango a little higher in the 8%+ range before giving my short positions a bit more leeway.

Finally, looking at the VIX futures premium, we see that it is running at a very low 3.6%. This should be treated with extreme caution. Futures a month out are basically sitting right on top of spot VIX. In a favorable short volatility setup, these premiums will be in the high teens or even low 20's. Basically, futures right now are saying this VIX spike won't go much higher. If they're wrong, they could respond by surging dramatically. Even if they're right, consider that VIX would have to drop below 10 to reestablish a premium of 20%, and that's assuming the futures don't move at all. So potential short profits seem to be capped at this time.

In conclusion, there might be some reasons to get back into a very small short volatility position. After closing up my SVXY last Friday and trading in and out of SPX puts this morning, I do have a small SVXY position now. But for one of those epic smashes we either need to see VIX drop significantly (and soon), or we need to churn through a few days with slightly elevated VIX readings until futures build up enough of a premium to finally drop again. Finally, there is still the question of what the general market will do. If we see another leg down from here, higher VIX readings are virtually guaranteed.