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Fear is Front and Center

As we move into the ninth day of the government shutdown and inch ever closer to the October 17 line in the sand, the apparent final hour for an increase of our nations debt ceiling, the CBOE Volatility Index or VIX is beginning to show signs of fear entering the market. We anticipated this might be the case in a few articles that we wrote for TheStreet (TST) last week. Our thought was that the longer the stalemate in DC lingered on, the more impatient the broader market would become. We are witnessing this today as the CBOE Volatility Index (CBOE) topped out at 21.34 just before midday, quickly approaching the 52-week high of 23.23.

However, one aspect of the VIX that we want to bring to light is the backwardation (spot prices are more expensive than future months) that we are seeing in the VIX futures. Looking at the October, November and December contracts, pricing is as such at 3pm EST: 18.60, 18.35, 18.45 respectively. The backwardation seen here in the front two months is not nearly as extreme as what we were seeing in the morning trade where all three months were inverted with October at 20.26, November at 19.42 and December at 19.25. The reason for the sudden reversal and selloff in the VIX is being related to recent rumors hitting the wire that meetings between Democrats and Republicans are beginning to take place on Capitol Hill.

So what is the take away from this "odd" behavior in the VIX futures? It simply means that the market is more fearful in regards to the short-term than it is about the long-term. Essentially traders are pricing in what they believe will be increased volatility around DC negotiations in the next month, but then revert back to a more normalized level in November. Hopefully implying that we come to some sort of resolution this month.

The reason I am writing about this phenomenon today is because watching the futures market can often give you a "pulse" for the market, as well as what "pulse" traders are looking for in the future. Essentially providing you with expectations that the market has for future price action. This gauging is not simply used as it relates to the VIX, but is also used by many professional trading desks to gauge future expectations in the S&P 500, interest rates, precious metals, oil, etc. By having an understanding of backwardation and contango (spot price lower than future months) one has the ability to discover an opportunity when extreme market behaviors occur, and thus position ones trading plan to take advantage of a normalization of the curve. This is a method of analysis that is available to any investor/trader, regardless of account size.

Travis McGhee


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At the time of publication, Travis McGhee held positions in SLV.

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