If you are going to be active in US equity markets (particularly with the SPX complex), knowledge of what is displayed above is great to have in your arsenal. This is a graphic display of something called the “VIX Curve”
The VIX curve presents the relationship of market participants to risk in the present and in the future. Now, you’ve likely heard of the VIX. It’s an index that measures “risk premium” in the market. In other words, it’s a measure of how much market participants are willing to pay to “insure” their risk. What you may not have known is that the VIX has a view of the next 30 days. There are other durations of VIX that combine with the 30 Day VIX to give us a “Curve”
There are 4 “curves” shown in the upper pane of the graphic above: 9D VIX (Red), VIX (Yellow), 3M VIX (White), & 6M VIX (Gray). These indexes are compared to the SPX (in purple) to help illustrate the relationship.
A “normal” VIX curve is shown with longer-term VIX at higher prices than nearer-term VIX. This is a function of a significant market principle: there are more possibilities for where price can go in the next year, as opposed to, the next 9 days. As a result, market participants are willing to pay more “premium” for protection further out in the future.
Using the VIX curve as part of your assessment, you can absolutely have a predictive model to discern the likelihood of an auction to make a macro turn by examining how participants are positioning themselves to risk over time. This is because auctions are behaviorial. Typically, we use profiling of auction inventory as our primary method to assess auction direction and quality….this is a complementing tool.
Here’s how this curve plays out both structurally and behaviorially:
- When markets are moving higher, market participants become increasingly complacent. They believe in the trend and don’t see the need for protection. When this complacency reaches a climax, we see the widest gap in the spread between near term and long term VIX. We call this “underpriced” risk. For me, when the 9D:1Y VIX ratio is above 12pts…risk is very underpriced.
- When risk is underpriced and we begin lower, market participants start to hedge. Believing that most dips will be temporary and ultimately bought, they reach for protection in the nearer expirations of the VIX. When we see near term VIX approaching the same premium as longer term VIX, the curve becomes inverted. This is what we call “overpriced” risk. These are the periods when 9D:1Y VIX is at parity or 9D is even higher. This is an “inverted” curve and calls for caution to market participants.
- Next, when risk is overpriced, the buyers of protection need prices to continue lower quickly to see any benefit from the hedging activity. As traders buy puts, dealers sell the puts and also sell futures against the sold puts to ensure they have no “delta” exposure. If auction doesn’t continue to get participants buying puts, once the puts expire, the dealers don’t need the short protection and buy back their futures, leading to the “turn” back higher. Note from the image above that the periods of inversion are often short and then lead to sustained periods of higher SPX prices as the curve “reverts” back to normal. Rinse and repeat.
Put simply…..US equities rally when the majority of market participants have overpriced risk and they sell off when market participants have underpriced risk.
This is related to 2 of the modules we take traders through in our DEVELOPMENT PATHWAY…
- MODULE 2: USING AUCTION SESSIONS TO FIND BETTER TIMES TO BE ACTIVE
- MODULE 3: DETERMINING AUCTION DIRECTION AND QUALITY THROUGH PRICE ACCEPTANCE
The timing of the VIX expansions relates to “better times to be active” and the complacency or fear is a measure of auction direction and quality.
What’s your view on the VIX curve? If you don’t have one, let’s talk. We offer free half-hour consultations for traders who don’t yet include this in their approach. Use this link to schedule a call.
