Don't Short The Market, Buy Volatility Instead

 |  Includes: SDS, SH, VIXY, VXX
by: Stephen Aniston

Being long the VIX (NYSEARCA:VIXY) is politically incorrect, but you should still do it occasionally. It could be the asymmetrical trade of the year.

After all, who in their right mind would want market turbulence? The buyer universe couldn't be happier right now. Liquidity is arriving at the rate of $85 billion a month. Retirement accounts look like a 401(k), not a 301(k). You know the politicians in Washington will make a deal at the last moment. The market marches higher, hedging is cheap. Life is good! I couldn't find a place to park much less sit down and have lunch on my ski getaway this weekend. That is, unless you are an option seller. If you are, you can't make any money selling options these days. You get nothing in return. I can't sell a near out-of-the-money put for more than 5 cents. I can't even buy a McDonald's meal with the $5 I would get. These guys are eating Ramen right now -- a week's worth of food for $5. Take that, food stamps!

A Historical Look at the VIX

The VIX closed at $12.46 on Friday. The all-time low is $9.31, recorded on Dec. 22, 1993. We are now at levels last seen during the glory days of 2007. Life was good back then as well.

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Source: Yahoo Finance.

Let's look at all the closes of the VIX below 10.

That's it, not even 10 data points: December 1993, January 1994, holiday season 2006, and January 2007. 1993-94 was succeeded by the greatest bull market in history. 2006-07 was succeeded by one of the worst bear markets in history. Notice that during the bull markets of 2002-07 and 1996-99, the VIX traded on average significantly higher than the present level of around 12.50.

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This is not to say that the VIX can't stay low for an extended period of time, but let's not forget that the economy was growing at 3%-4% during the 1996-99 and 2002-07 bull markets with much less partisan discord in Washington and much more conventional monetary policy. And I don't remember the entire world announcing contractionary GDP numbers for Q4 (Christmas season) then. Here are the GDP numbers announced the past two weeks for Q4 2012:

To put it simply, the levels we are seeing today are highly unusual given the fundamental backdrop.

The "Fear Index" Myth

The media commonly refers to the VIX as the "fear index." If it is high, there is a lot of fear in the market. The world is not in a good place. Well, here is the definition of the VIX index, according to the Chicago Board of Exchange (CBOE):

The VIX® Calculation

The calculation of the VIX index uses two series of SPX option contracts -- the front month and the second month -- as long as the front month has at least one week until expiration. When the front month series is one week from expiration, then the current second month series rolls up to become the new front month in the VIX index calculation, and the current third month becomes the new second month.

The VIX index calculation uses a wide range of at-the-money and out-of-the-money SPX call and put options. The midpoint between the bid and ask prices of actively quoted contracts are used in the VIX index formula. The first result of the calculation is the price of a synthetic at-the-money 30-day SPX option contract that expires exactly (to the second) thirty days in the future. The second result of the calculation is the implied volatility of this synthetic contract, and that implied volatility is quoted as the VIX index. This calculation is updated every 15 seconds throughout the trading day.

Notice that the calculation includes both put and call options. There is a widespread misconception that the VIX index tracks only put option activity. This couldn't be further from the truth. It incorporates call option activity as well. As a result, the VIX can go up when market participants expect higher prices as well because they will be buying more call options. This is confirmed by the VIX and S&P 500 comparison chart above when the VIX was in a 20-30 range for majority of the late 1990s -- the best of the good times. And obviously in bad times, the VIX spikes up significantly as well.

The Quiet, Overstretched Market

The NYSE margin debt in December 2012 was at $330,356 million -- levels not seen since 2007 when investors were flush with cash and were getting leveraged to invest in the market and in housing:

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The recent market rally can probably be attributed to investors getting leveraged to buy into stocks, not because they are getting money out of bonds to buy stocks. In addition, the S&P 500 short interest (as percentage of float) is also at levels not seen since 2007, and the 13-Day Hi/Lo Spread is also at 1.35%, lowest level since 1986.

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Source: Bespoke Investment Group.

These are all indications that the market volatility is at an all-time low and stock prices are quickly going nowhere moving in a tight range. Market speculation by retail investors is on the rise and stress is building in the form of higher leverage.

VIXY and VIX Are Not the Same

Let's do some technical analysis with a recent chart of the ProShares VIX Short-Term Futures ETF. Some people prefer the iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX) because it is much more liquid, but I like the VIXY for this analysis because the price is closer to the actual VIX value. An overlay of VIXY and VXX provides identical performance, so for purposes of this analysis they can be used interchangeably:

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  1. There is a nine-month wedge developing here. We are near the end of the wedge -- very bullish.
  2. The Friday (Feb. 15, 2013) candlestick was a doji star -- a trend reversal indicator.
  3. The RSI is near 30 -- oversold territory.
  4. There is a clear rounding bottom forming with each down move weaker than before since the November election.
  5. Bollinger bands (not pictured) are very narrow right now, signaling an imminent breakout.
  6. And most important -- significant volume. This particular chart doesn't show it, but the volume in VIXY is two to three times bigger than it was last year. Somebody is buying all that they can get.

It is very important to understand that the VIXY and the VIX are not the same. The VIXY is meant to track the VIX, but it does so very poorly. If the VIX stays at the same level, the VIXY will decline. If the VIX declines, the VIXY will decline even more.

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The VIX has declined 30% in 2012. The VIXY? It is down even more at 78%. Ouch! This is not an instrument that you should purchase and stay long very often. The odds are 2-to-3 against you. The VIXY is usually best shorted. Going long the VIXY should only be done for a short-term play or a short-term hedge. Under no circumstances do you buy and hold this long term. You will lose too much money.

The Asymmetrical Trade

So here is the trade I am proposing. If you buy the VIXY at $12.00 (Friday close was at $11.77), your potential downside is $9.38. This is a loss of 25%. It is not insignificant and you should cut your losses at 10% anyway. But a move lower is very unlikely at this point with the March sequester looming, a potential government shutdown, another European summer of turbulence, and -- more importantly -- declining economic numbers in all major economies. The VIX has spent 88% of its lifetime above the 12.5 level. There is an 88% chance that the VIX will go up from here; 9-1 odds is the definition of an asymmetrical trade.

In the short term (one- to two-month horizon), the VIXY will match the return of the VIX. A simple mean reversion move of the VIX up to the long-term average of 20.54 will result in a 64% return. A move to 30 will be a 150% return. If the market goes up the VIX will not spike quite as much, but I think any resuming of trend in bullish activity above the 14,000 level on the Dow Jones Average will increase call option buying quite a bit -- and that will still result in a VIX in the 15 range. That represents a return of about 25%. I am in the bearish camp on the S&P 500 right now and I think the market goes down from here. In an earlier article, I was advocating hedging your long positions with a short S&P ETF -- either ProShares UltraShort S&P 500 ETF (NYSEARCA:SDS) or ProShares Short S&P 500 ETF (NYSEARCA:SH). I now think there is a better way to do that for the next two months. If you don't want to observe losses on your SH or SDS hedges while the market is going up in the face of declining economic output, buy the VIXY instead. It has the added benefit of going up even if the market goes up. At these levels, the only place the VIX can go from here is up.

Disclosure: I am long VIXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.