One of the signals that I use to determine when there is tension building in the market for a decline is to look at where front month VIX futures are in relation to the spot VIX. For reasons I will describe below, a positive premium of front month (M1) over spot VIX normally exists and converges over time. Abnormalities of this behavior indicate shifting investor sentiment.
The first concept to understand is that while spot VIX is the current 30-day measure of implied volatility of SPX options, VIX futures are the measure of the expected implied volatility on the expiration date for a given month. This means that the front month VIX futures is further out in the future than the spot VIX. Once the expiration date for the front month is reached it expires and VIX futures roll over to use the next month as front month.
The second concept is that the prices for each month of VIX futures create a curve called the term structure (you can see a visualization of the term structure in my previous post here). Normally the term structure is shaped such that VIX futures that are further out are more expensive than nearer months, a condition known as contango.
By combining these two concepts you can see that there is usually a premium of M1 over spot VIX since M1 is further out in in the future than spot VIX and the term structure is in contango. Now since spot VIX in a constant 30-day measure of volatility and M1 is forward implied volatility on a fixed day for the next month, the amount of premium gradually decreases as we approach the expiration date.
The chart below provides a 55 month view of the daily reading of the percentage of M1 above (or below) spot VIX. Note the periods circled in red where the value go briefly and shallowly negative followed by a spike downwards where VIX becomes much larger than M1 as the markets sell off and traders drive up the value of the spot VIX. This can be contrasted by the more confident periods in which spot VIX remains below M1 for a prolonged duration indicating a more confident market (see green "floors").
The downdrafts identified on the charts started on the following dates:
1) 9/9/2008 (subprime crash)
2) 5/6/2010 (flash crash/Greece debt problems)
3) 3/16/2011 (Libya skirmish)4) 7/27/2011 (Debt ceiling crash)
As you can see, the market provides useful signals when sentiment is changing and is starting to get unstable. As market sentiment changes for the worse, you will see a gradual change in the term structure where the spot VIX rises above front month futures, a condition defined as backwardation. There will be occasional periods of slight backwardation before a more pronounced upward move in the spot VIX which is typically accompanied by a marked downturn in the market (S&P 500).
These movements are not just a coincidence -- it explains investor sentiment. When the general market is doing well, investors tend to get complacent and expect that it will continue to do well. They continue to add to long positions (often with leverage) and do not have much interest in buying and holding options for protection. However these brief dips into backwardation suggest that options are underpriced and rise after a series of events remind investors of broad market risk. They start buying protective puts -- initially in smaller quantities and holding only briefly, followed eventually by broad buying of protection driving up both spot VIX and VIX futures as market risk materializes.
For VIX traders out there this means that there is an increased risk with long XIV positions and extra caution is warranted in the coming month(s).