Reading Tea Leaves
Vol #34 - April 16th, 2021
When we project what the world will look like next, we’re constrained by our current perspective. Science fiction has been famously wrong about the pace and direction of innovation. Yesterday’s space fantasies include self driving vehicles, but nothing close to social media.
Forecasters tend to de-emphasize outcomes that they find undesirable, and wallow in optimism or outcomes that benefit them. The line between forecaster and promoter is thin.
In finance, the futures markets price the current expectation of what’s going to happen next. Two sides make a market, and speculators and hedgers can trade contracts that pay out based on some future value.
The Chicago Board of Trade was founded to standardize and organize the transactions in grains coming in from the heartland. Farmers wanted certainty about the prices their crops would fetch so they could manage growing expenses. Buyers of grains wanted certainty on their own inputs and so was born a market.
Futures products have expanded across different asset classes to cover everything from volatility to currencies. Multinational corporations and large asset managers are the major players, and financial media reads the tea leaves about what futures portend.
The relationship between different futures prices is called the term structure. When you plot the price of futures on the same commodity over time, the line connecting them describes the market’s view on where prices will be when.
In traditional commodity markets, the “normal” state of the world is contango. All other things being equal, future prices will be slightly more than current prices by approximately the cost of carry. The difference between buying a bushel of corn today and a bushel in 6 months is mostly driven by how much a bushel of corn costs to store. Oil traders with access to storage and transportation have reaped huge gains when the futures price of a barrel rises above their costs.
One futures curve that is particularly interesting to options traders is the VIX term structure. The volatility index has listed futures, which derive their value from the price of the VIX on the contract’s expiration date. While the markets have been rallying recently, and the current VIX price has fallen below 17, are futures seeing trouble up ahead?
While on the surface higher future volatility seems scary, this tends to be the normal state of the world. Volatility is mean reverting, and the distribution is skewed. We tend to see long periods of calm, interrupted by short bouts of high volatility.
The asymmetry of risk here means that future prices will naturally drift higher. Volatility can only go so low, but it has explosive - if temporary - upside potential. The June future is trading around 22 right now. An extremely low print would be about ten points lower. However there are a range of outcomes where we could print ten, twenty, or forty points higher. Fighting convexity can be very expensive.
The carry in the VIX can be thought of as a cost of hedging, or even a manifestation of the volatility risk premium. Most market participants are long equities, and want to hedge their exposure for a market crash. This leaves the “naturals” as buyers of volatility, and creates an insurance premium.
While it may not be proscriptive, the tea leaves of VIX term structure can be informative. Kinks and relative pricing changes indicate subtle shifts in timing expectations, and the relative overall level is a good temperature gauge of investor sentiment.
When predicting the future, we need to be aware of the state from which we’re looking. While we may be biased about the potential for future volatility, there’s a benefit to protecting against the unknown unknowns. One participant’s bias is another’s good night’s sleep.