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Fear is back -- big time. CBOE Volatility Index (VIX) was up .93 to 20.34 Tuesday to recapture the 20 handle for the first time in more than 3 months- spot VIX almost touched 21 as President Obama took the podium to update the public on the budget and debt ceiling crisis that is underway. The index has now rallied 55% since September 20, as the S&P 500 has come down 4% from recent highs. Trading in VIX products has been very heavy, but the term structure of the VIX futures market indicates an expectation that things will settle down by November.

Options on CBOE Volatility Index established a new single day volume record Tuesday after nearly 1.8 million contracts changed hands. The flurry of activity in the VIX pit was across a number of different strike prices. November 14 puts were the most active. 93,170 contracts traded and the flow created 9,500 contracts of open interest at that strike. January 24, November 21, and January 18 calls saw the biggest increases in open interest among the VIX contracts.

Not to be outdone, VIX futures saw extreme volume as well. 322,000 contracts traded on the day, which is the fourth highest on record, according to Bloomberg. Now, after the recent spike in VIX, the futures on index for the next six months are below the spot price (see graphic below). For example, November and December VIX futures are both below 19.

A high spot VIX relative to near-term futures contracts, known as backwardation in futures lingo, happens during times of stress when investors are worried about a short-term catalyst that might drive the S&P lower. The government is shut down and lawmakers are running out of time to raise the debt ceiling. Washington will exhaust its authority to borrow money by October 17 and run out of money to pay bills between October 22 and October 31, according to a Congressional Budget office estimate. VIX is rallying, as the repercussions if the US defaults on its debt could be catastrophic. But looking out to November and December VIX futures, prices seem to suggest that market participants expect the volatility to settle down over the next month -- i.e. a debt default is the least likely scenario.

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At the time of publication, Henry Schwartz held no positions in the stocks or issues mentioned.

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