One of the more telling passages in When Genius Failed, Roger Lowenstein’s classic account of the 1998 undoing of Long-Term Capital Management, involved the disappointment of outsiders upon seeing LTCM’s positions for the first time. Surely the assorted Nobel laureates and erstwhile Masters of the Universe had all sorts of exotic positions and derivatives, right? Um, no; for the most part, they managed to get both themselves and the remainder of the global financial system into all that trouble mostly by being long mortgage-backed securities and short Treasuries.
This was a case of position size leading to illiquidity. Most of the time, though, it is exotic positions traded not on a central clearing platform but bilaterally in the cash market that lead to a liquidity crisis. Occasionally you get a combination of massive size and a high degree of complexity, such as the 2008 credit default swap position of AIG; ah, those were the days.
Simplicity is a virtue in most walks of life, trading included. Which brings us to our present subject, whether you should trade expected price movements in one market, the S&P 500 (CME:ESZ14) (SPX), via an attribute of that index, implied volatility as measured by the CBOE Volatility Index (VIX). While the question of whether implied volatility is an asset class cannot be answered here because there is no widely accepted definition of what an asset class is, we should be cautious in defining it as such. The VIX provides a reading of future price uncertainty of the SPX; which makes it an attribute of an actual asset. The VIX itself is an intangible concept; unlike recognized financial assets you can neither own it nor detach a stream of returns from it.
The question whether volatility is an asset comes into play when we consider the forward curve of VIX futures, which are priced off the VXB or “jumbo VIX.” Unlike a standard futures forward curve where there is a defined full-carry pricing structure where a futures contract represents the spot price plus all of the physical and financial costs of holding it to the delivery date, the VIX forward curve represents a series of forward-start one-month fixed legs of volatility swaps.
The price of a three-month VIX future should not reflect current movements in the spot VIX index so much as the level at which volatility and variance swap traders can agree to do business starting three months from now. The implications here are simple: Trading a three-month future based on current VIX readings is like seeing a forecast for rainy weather over the next few days and ordering an umbrella to be delivered three months from now.
Let’s illustrate this by comparing the pseudo-forward curves for VIX futures on Feb. 3 and July 22, 2014; the former occurred near the low of a selloff and the latter on an approach to a new high in the SPX. The spot VXB values are highlighted in large markers and the pseudo-forward curves between February 2014 and April 2015 are drawn with high-low lines between the two overlapping contracts, those for September and October 2014 (see “Taking the differential,” below).
Please note how the February pseudo-forward curve was inverted while the July pseudo-forward curve was sloped positively. The market judged, correctly, in February the surge in the spot VXB would not lead to a sustained period of high volatility, and it was pricing in higher forward volatility in July. Anyone who went short either September or October VIX futures in February would have captured 62% and 55.4% of the spot VXB’s decline by July 22, 2014. That is a small reward received for a large risk assumed.
If you are about to retort, correctly, that most traders might be willing to confine themselves to the front-month futures contract, you still have the partial-capture problem. If we map the spot VXB changes and the front-month VIX futures changes for each day when the February-July 2014 contracts were the front-month, we see a dominant pattern of much larger VXB changes…and a few days when the VIX futures moved in the opposite direction (see “Volatility divergence,” below).