Since Chairman Bernanke's talk in May of "tapering," the market has seen a lot of turmoil. The S&P 500 dropped below its 50-day moving average, volatility spiked, and all volatility-related products (ETFs/ETNs) sharply spiked as well. However, in the past week the markets have rallied and the S&P 500 is back above its 50-day moving average. Also, volatility has sharply dropped, and along with it volatility ETFs have crashed.
Click to enlarge images.
I believe that this earnings season will provide good upside for the market. The expectations have been lowered so much that companies should have little trouble beating them. With a trailing P/E of 14, the S&P 500 has room to grow. More importantly, however, the market digested the positive jobs reports last Friday with a huge rally, which indicates to me that the market is comfortable with a September start to tapering. Finally, in general, volatility drops when markets rally, and markets rally during earnings season. Historically, the end of summer is a time when volatility drops after the summer spike (that's "Sell in May" in action).
With this, I expect volatility to drop back to the levels seen in May before Bernanke's tapering talk. Currently, the S&P 500 Volatility Index (VIX) is at 14.35 (as of the close on July 9, 2013), and testing the May lows should bring it to 12.5 levels. Note that there is more room for the VIX to fall, as the 52-week low is around 11.
When the VIX drops, the volatility ETFs drop in tandem. I am particularly interested in the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY). This ETF is extremely sensitive to movements in VIX, as the following chart shows:
The chart above uses historical data over the lifetime of UVXY to show how UVXY changes along with the VIX. As the regression analysis in the graph shows, there is a strong positive correlation between the two. The equation on the bottom right-hand side of the graph shows how to predict a change in UVXY given a certain amount of change in the VIX.
Plugging in various potential values of the VIX at the end of the next six weeks, and using the above equation, we get the following potential values for UVXY:
|$ 12.0||$ 30.4|
|$ 12.5||$ 32.3|
|$ 13.0||$ 34.2|
|$ 13.5||$ 36.1|
|$ 14.0||$ 38.1|
|$ 14.5||$ 40.0|
|$ 15.0||$ 41.9|
|$ 15.5||$ 43.8|
|$ 16.0||$ 45.7|
I believe the VIX will not spike above 16, given that in the first five months of the year there have been exactly five cases where such values were seen, and the VIX went down almost immediately after that. Given that, those who are comfortable with shorting should go ahead and do so. However, I do not like the concept of infinite downside, so I instead recommend buying at-the-money August puts on UVXY. The following table shows the risk/reward profile for various put options on UVXY:
In my opinion, buying the at-the-money put with a strike of 53 provides an upside in excess of 100%, with a limited downside of less than 10%. More adventurous souls may go further out of the money, while more conservative folks can buy in-the-money puts. Personally, the strike 55 put is most attractive to me in terms of risk/reward.
That said, there is no guarantee when investing in volatility products, especially options on volatility products. Any externality -- Feds talking about even earlier tapering, the Greece bailout blowing up, Egypt descending into complete chaos that impacts the rest of the Middle East -- can cause a spike in volatility and expose the above strategy to risk. So, I would recommend investing only the high-risk part of your portfolio in this and only a small share of that part as well. Given the outsized potential rewards, there is no reason to take undue risk.
Disclosure: I am short UVXY. 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.