VIX Backwardation Part 2: Uncharted Waters

 I'm beginning to think more and more that we really are in uncharted waters/Stranger Tides, at least for VIX.  We are in the 2nd week where VIX futures are in backwardation and its only getting steeper.  Some theoretical causation for this from Wallstreet Journal/ Zerohedge is a "feedback loop" from many big funds shorting volatility.

At the close when I'm writing this I'm looking at over 4% backwardation with the front month higher than May AND June.  Furthermore in looking at contango data back to 2004, the VIX futures were only in backwardation when spot VIX had a high of under 15 once on 3/8/2007, and the backwardation was -.29%. 

Looking back even recently to ~2011, we can see every backwardation event was accompanied by a high spot VIX >20, until now.

So what to do?

Personally, I've added short SVXY calls to my position, extending my downside breakevens and adding a little long vol to take advantage of the futures curve.  Going forward, if this structure holds, I think I'll lean towards SVXY strangles/adding short calls onto my existing short puts as the backwardation takes a lot of risk off of the upside.
I'll probably get assigned stock on the puts on some of these expirations, at which point I'll basically be in SVXY covered calls, keeping the long term short VIX assumption.

But does this make sense?

I'm still holding to the core belief that VIX has to return to contango, as the concept of free insurance just doesn't make sense.  However, at the same time I'm not rigidly holding to the belief that the market or any part of our modern era has to make sense.  Flat earth and geocentrism made perfect sense as well!  (Now mix flat earth with uncharted waters)

 

With volatility as an asset class, it got me thinking about the other asset classes that don't make sense-

Negative interest rates- If you explain the concept of savings to a small child, or even mildly lucid marsupials, they will point out immediately how little sense it makes to lock in a loss of capital.  Of course you can academically say there are reasons and structures for why interest rates will go negative, but the glaring conceptual problem on the surface remains.

Swap/Treasury rates- This is less of a retail/small investor trade, but looking at various articles on over-the-counter swaps trading lower than 'risk free' US Treasuries, we see another glaring issue- How would something with more risk than an identical product ever be worth less, how is there no floor?

Has VIX ascended into the now trinity of asset classes which make no conceptual sense?  I was trying to wait a little to start writing about this as who knows, it could correct tomorrow.  Even if it does, that doesn't change the fact that a new floor or ceiling has been breached for volatility, so I might as well yell anyway.

One upside to all of this is the unknown of the market holds, and surprises us in new ways each time.  At the first level of investing we think something is overvalued or undervalued and take the corresponding position.  We soon learn that something "overvalued" can keep going up, even to a $1 Trillion market cap.  For this reason I think you should throw fundamental analysis out the door if you haven't already.
Step two is to trade based on mechanics such as convergence/divergence, contracting volatility, etc.  Unsurprisingly even then, trading based on a mechanical fundamental such as "interest rates can't be negative" will eventually break down.  The upside of all of this is that any market (even one of ideas) can be two-sided, which theoretically means continuing liquidity.

I am still SHORT VIX! However- given the pricing of futures I think it makes sense to convert some short SVXY puts to strangles, adding some premium where there is a little less risk than there was previously.
And if none of that makes sense, in addition to the fact that its all probably wrong, instead just look at what the futures curve is telling you:

  Just do it!

Low VIX Contango Thoughts

A few times over the last two weeks I noticed my trusty blade glowing blue, noting VIX had dipped into backwardation-

Tastytrade had a great discussion yesterday which pointed at some of the underlying macro VIX issues that you have to contemplate when having short VIX as a core position.  In summary, backwardation in VIX futures at such a low level has been almost unheard of and potentially reflects how much big money could be behind short VIX.  (Along with their trade idea of getting long VIX as without much contango you are getting long VIX without the roll cost which should be free money)

Is the small front month backwardation after the tiniest dip just a visual representation of buy the dip?  Conceptually the futures curve is pricing in a very short term vol contraction, which correlates with an equities rebound. 

 With this backwardation oddity I went off walking, rambling, thinking about futures curves in general.  Will the VIX curve always look the same?  As VIX products are traded more and more (and the equity options they are based on)  will these weird curve changes become more commonplace?

Would it make sense for a theoretical VIX futures curve to be a flat line at 15 or whatever the average is?  I keep coming back to the conviction that VIX futures have to keep in contango most of the time because there will always be uncertainty.  To lose the long term contango structure is saying  "the future is solved" and in finance terms there is no risk premium associated with thinking "some risk will occur in the future."

Will we see a much flatter front 2 months on the VIX curve when /VX is in the low teens?  I think this is definitely possible as more backtesting shows that periods of low VIX lead to more low VIX on average.

Going back to the actual trade ideas, the short term backwardation was a theoretical impetus to get long VIX with very little roll cost.  On paper that trade looks good but in the larger scope of assuming that the very backwardation implies a short term vol contraction, I think it is hoping for two opposite things at the same time.

Whether I end up wrong or right in the short term, the whole event was a time to contemplate conviction in your beliefs and process.  If I believe in the structure of VIX contango, then I have to be short VIX. (with risk management/ cash position)  Is this what religion or faith feels like? Is this the church of SVXY?