VOLATILITY REVERTING TO THE MEAN
Courtesy of Surly Trader
It is fortunate that I wrote my previous article about stagnant volatility the day before a strong ISM number came out which created a robust equity rally and a precipitous decline in implied volatility. The VIX has decline nearly 15% this week. VIX futures have fallen rapidly across the curve, but if this rally can be sustaining it seems that the futures have a long way to fall:
The front part of the curve fell quickly along with the VIX, but the months further out remain stubbornly high
The gap between the VIX Index and the 2nd month of VIX futures is at 6.86%, which is just off the absolute 6 year high of 7.46% established on August 6th. This gap cannot persist forever:
The gap has to narrow, one way or the other
If the equity markets are able to hold onto their ground, then this looks like a great time to bet on a decline in VIX futures by shorting the October and months further out on the curve (over 32% for Jan 2011?!). If instead we believe that September and October are going to be rotten months, then it would be wise to make a pairs trade through a delta hedged long option straddle in the S&P 500 along with a short position in the VIX futures.
