VIX Says, ‘Blah Humbug!’

A prominent site that I shall not name had a post recently noting that S&P 500 (SPX) futures had “backwardation.” By that the writer meant that the further out you go in time, the lower the price of the SPX future. He used March SPX futures as an example to suggest that traders anticipated the index would be lower in the spring.

Well, that’s not quite accurate because, in the case of SPX, it�s simply a math problem. The premium (discount) in a futures contract is purely a function of the cost of carrying the contract. It’s basically the dividends you earn between now and March on the basket of stocks minus the interest paid during that time period. With interest rates miniscule, it stands to reason that a future with one full quarter to go would trade at a discount.

CBOE Volatility Index (VIX) futures, on the other hand, do have a sentiment angle to them. Because there are no dividends or cost of carry associated with these, the premium, or discount, in a VIX future actually does reflect sentiment.

Here’s a snapshot of how we closed Wednesday:

It’s important to remember that a given future price is where the market expects to see the VIX close on the day the future expires. It does NOT reflect market expectations for volatility between now and that expiration date. In other words, you can speculate today on whether the VIX will close above or below 23.70 on March expiration by buying or selling the VIX March future. But if you want to bet on SPX volatility between now and March expiration, you would have to do something radical like … trade SPX or SPDR S&P 500 (NYSE: SPY) options. Right now, at-the-money (ATM) SPX options trade for about a 17.75 volatility.

Sounds low compared to the VIX, no?

Well, the VIX calculation incorporates a bevy of out-of-the-money (OTM) SPX puts, and those puts trade at a much higher implied volatility than the ATM options. The VIX itself averages about 4 points above where a normalized ATM option with 30 days to expire would trade.

What can we conclude from this little exercise?

There’s some sentiment that VIX will lift between now and March (and every other month as you go out in time). But it�s not overwhelming. And that sentiment has abated during the past few months. A premium of $5.50 out three months is actually very cheap when you consider that the VIX itself is hovering close to its post-flash-crash lows. If forced to read the sentiment from the VIX board above, I’d say its neutral, but bordering on complacent.