Why is the VIX so low, what's driving it, how low can it go, and for how long? Part 2 - The Curve Trade

Level 2 - A carry-efficient trade for the current set up on S&P 500 volatility

In part 1 of this series, I went over the current low level of S&P 500 volatility as shown by the VIX index which has got traders scratching their heads. For more information on the connection between the VIX index and S&P 500 volatility, refer to this post from the Zero to Options Hero series.

In this post, I will quickly run through two different trade ideas that I like which take into account this price action and are good setups to generate positive expected returns while limiting the downside. This will be a good introduction to how volatility traders set up winning trades in the market.

Trade 1: Betting on a rebound in the VIX while limiting carry costs due to the steep VIX term structure.

As can be seen in the below chart, the current level of the VIX index (VIX spot), is below the level of the futures (or we can say that the VIX futures term structure is upward-sloping.) As mentioned in part 1 of this series, typically implied volatility rebounds after the summer months as traders and portfolio managers gear up for more active trading as the 3rd quarter of the year starts in order to make their budgets. A naive volatility trader would want to bet on the VIX rebounding by mid-September by buying a 3-month futures contract on the VIX, however, the chart shows that SPX 1mth realized volatility is below VIX spot and the curve up to 3mths in the VIX futures curve is extremely steep. The yellow bars show that the historical percentile of current steepness (as measured by 2mth VIX - 1mth VIX, 3mth VIX - 2mth VIX) is at very high levels versus the past 15 years of prices. If a trader buys the 3mth VIX futures contract, the 3mth VIX - 2mth VIX rolldown is at the 91st percentile.

The concept of rolldown is well known to futures and interest rates traders and is also tied to the idea of cost of carry. If we imagine that the VIX futures curve is unchanged over the next 3 months in magnitude and curvature, then a trader who is long the 3mth VIX futures contract would lose P/L every day as the price of the future ‘rolls down’ the upward-sloping curve. Another way to think about this is that the curve is already pricing in a rebound in the spot VIX index by the end of the summer, so to make money betting on a rebound the spot VIX has to rebound by more than the rolldown effect, which represents a hurdle to the P/L.

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