Media, many investors as well as many traders still talk about the VIX showing a lot of fear. Sure, the VIX is elevated still, which is natural after the sell off in October, but looking purely at the VIX is often misleading.

In order to really see how risk is priced, and how the “fear” really is, you need to look beyond the simple VIX index. Below chart shows the SPX term structure. Term structure measures the various months options of the SPX index.

A normal curve (normal markets) is referred to being inverted, short dated volatility trades lower compared to longer term volatility. Very simply explained, this happens because when markets are calm, short dated options lose more time value as expiry is approaching “soon”, while longer dated options are less sensitive to the theta decay.

The flip side of this is the gamma. Short term options have more Gamma. Options traders refer to “buying Gamma selling Theta”, i.e. when you buy short term options you “get” Gamma, but for this you have to “pay” the Theta decay (the value of the option declines every day, ceteris paribus).

Longer dated options have more Vega than short term options, and are therefore often used for structured books hedging longer dated Vega risks.

All in all, short term options are much more sensitive to volatility and market moves.


Something far out of the money can simply become in the money if markets start moving quickly and therefore increasing the options probability of becoming in the money (For more reading on derivatives, see our education material on derivatives and option trading strategies).

Back to the chart of the SPX term structure. Note how the curve was trading inverted 3 months ago (green). Back then a popular strategy was to sell short dated options, collect the Theta and hedge the Vega with longer dated options. This was a crowded trade among the hedge funds, and eventually, as we warned, blew up.

This caused a frenetic urge among those funds to close this massively popular trade and shocked the volatility curve as positions were closed out abruptly. First thing the short Gamma players needed to do is sell Deltas in order to manage the Delta risk, only to later start closing out the options positions. In terms of low volatility, these strategies work well, but when volatility explodes, they become fatal.

One of the main problems with these types of strategies, is the fact most investors have limited knowledge of managing such portfolios as the risk becomes convex. Quants will explain these strategies to you and they will sound awesome, but it is a rare breed to find those quants who can manage such exploding Gammas etc.

As markets collapsed, the term structure exploded as well. The blue line shows how the curve had gone “nuts” in late October (blue). Today things are normalizing and we trade according to the orange line. Simply looking at the VIX index will not show you this.

Another important part of looking beyond the VIX index is to look at the VIX curve and how the various futures contracts of the VIX trade. Below is the spread between the first and the sixth month VIX futures. Same arguments are valid as the above, shorter term VIX futures are more sensitive to a volatility shock than the longer term futures. In calm markets, this spread trades in negative territory. In times of stress the spread trades in positive territory.

Note how the spread has come off lately and is now small negative.

Last time the above VIX spread traded at these levels was in mid-October, as well as around November 8th. In both those instances, the SPX index traded at the 2800 level, 4.5% higher.

Looking beyond the VIX index offers clues about the fear, what people are pricing as well as some insight to where SPX traded last time the deeper DNA of VIX was trading at these levels.

We stick to our arguments that a possible unexpected Santa rally could catch the crowd wrong again.

Source; charts by Bloomberg