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Don't worry, the meaning of the graphic will become clear later. Spoiler alert. In this article I detail a portfolio strategy based upon the VIX index. The "theory" portion discussion is based upon the actual VIX index. There are significant performance differences between the actual VIX Index and the ETFs that are based upon it. Significant adjustments must be made when implementing the "theory" to account for the reality that the VIX ETFs have significant tracking error. Theories based upon the VIX Index may not translate into real world portfolio management due to the lack of available securities that accurately reflect its behavior.

I recently wrote an article about natural gas and why I didn't think the recent spike in prices was likely to hold. The investment theme I outlined was the same theme that I relied upon last year for an extended series outlining a bearish theme for gold. The theme is simple, fear and panic are temporary and transient phenomenon, and that market gains that occur during a panic are likely to be reversed. We've all heard the saying, "buy when there is blood in the streets, even if the blood is your own." The advice Baron Rothschild gave in the 1700's is as applicable today as it was then.

Fortunately today we have many tools that Baron Rothschild didn't have to help quantify when "blood is in the streets." In today's modern computer and information age, we have been able to quantify the level of blood in the street. The CBOE calculates an index called the CBOE Volatility Index or VIX Index. The calculation is a rather complicated calculation, but the important aspects can be boiled down to 3 talking points:

1) The calculation is dynamic and based upon a strip of securities and date range, not a moment in time snapshot of a single fixed security. Real time pricing is available for the VIX index.

2) The index is derived from objective market data, and uses options pricing as its source of information. Premiums built into the calls and puts give insight into the optimism and pessimism of the markets. As fear grows, the put premiums grow relative to the call premiums, and as greed grows, the call premiums grow relative to the put premiums. This makes the VIX Index similar to the Put/Call Ratio. The changes in volatility expectations discounted in these options is the foundation of the VIX Index. Both fear and greed can drive the VIX Index higher, but because markets tend to gradually trend higher and then suddenly drop lower, the VIX Index tends to be a better "fear gauge" for picking market bottoms, than market tops.

3) The VIX Index is similar but different from the implied volatility calculated in the Black-Scholes model. It is more flexible and dynamic.

Much of the data used in tracking market sentiment is derived from the options market. On the one side is Put/Call data, which of course, is used to arrive at the daily Put/Call Ratio. More misunderstood is the volatility data that is used for arriving at values for the S&P 100-based VIX, and the Nasdaq 100-based VXN. Volatility in this context refers to Implied Volatility (IV), which is a factor in the pricing of options, particularly Put Options, which are used for portfolio protection, and as a way to profit from downturns in the market. The greater the amount of fear of financial loss, the more the "fear factor" is priced into the cost of Puts, and consequently, IV tends to go up. VIX readings of 50 or higher are associated with near-to-intermediate term market bottoms, and VXN readings of 70 or higher with the same.

To clarify some confusion that may be created from the above quote and point #3 above, the volatility measured by the VIX Index is not the implied volatility calculated using the Black-Scholes model, but similar.

Relationship between VIX and Black-Scholes Implied Volatilities

Dupire and Hagan6 characterize Black-Scholes implied volatilities when the underlying volatility is not constant. The Black-Scholes implied volatility of an option with strike price K is approximately equal to the expected volatility over the most probable price path whose ending value at expiration is K. This is in contrast to VIX which is the square root of expected variance over all possible volatility paths. Carr and Lee7 find that a Black-Scholes implied volatility comes closest to expected volatility when the strike is at-the-money.

The key points, however, aren't the details of its calculation, it is how it is used. The VIX Index is a market tool useful in identifying market bottoms, especially fear driven market bottoms. There are other uses, but using the VIX Index as a "fear gauge" is the subject of this article.

The investment approaches outlined in this article tend to be opportunistic and tactical, rather than strategic and buy and hold. The purpose is to develop a portfolio strategy where the VIX Index can be used for hedging purposes. Events like 2008 can wipe out an entire decade of returns in a matter of weeks, so developing a tactical strategy may be worth the effort. Markets don't trend forever, they tend to form extended trading ranges that may exist for decades, they then break out of those trading ranges and run up to a higher level, and then start forming a trading range again that may last decades. The Dow Jones Industrials traded below its early 2000 peak as late as late 2011. We are still well below the peak of the NASDAQ 100 set in 2000, and it wasn't until just last year that we broke above the peaks set in the Dow Jones Industrials and S&P 500 first set back in 2007, so there is a time for buy and hold and there is a time for tactical, the key is identifying when to use which strategy.

Why I'm leaning towards a tactical approach in this market is because I simply don't buy the recent market strength. In my opinion the markets have rallied for all the wrong reasons, and some of those reasons are reversing themselves.

1) In my opinion the only thing supporting the fragile recovery has been monetary policy. Fiscal policy is a disaster, and contractionary at best. The Federal Reserve has begun to remove what little support there is for economic recovery, and the markets put little faith in the outlook for growth oriented fiscal policy. That isn't a political statement, that is a simple market observation. The Fed announced this week that it would continue with the "Taper." The market reaction to this was that interest rates FELL. There isn't an economics textbook ever written that would predict interest rates to FALL when the Fed slows buying bonds by $10 billion/month. The current market reaction is 100% contrary to what is written in textbooks. Fortunately, the markets are smarter than the textbooks, and they understand a failed fiscal policy when they see it.

2) Slow economic growth isn't likely to lead to stronger earnings. Unless corporations can continue to find ways to cut costs, earnings growth is likely to slow going forward. A slowing United States will also translate into a slower growth in China and other emerging markets. It is no surprise to see emerging markets hurt the most by the Fed's decision to "Taper." Weakness overseas is likely to drag the US markets down with them.

Goldman Sachs analysts wrote last week that when MSCI's emerging markets index (.MSCIEF) falls at least 5 percent, the S&P 500 (^GSPC) tends to fall by half of that. The MSCI index has dropped 11 percent since an October peak of 1,047.73.

3) Artificial efforts to drive stock prices higher like stock buybacks can't last forever. Sooner or later, earnings growth must return to the markets to drive them higher. That is unlikely if the inability to craft a growth oriented fiscal policy pushes the United States back into a recession like it did in the second term of FDR.

4) This current market cycle is entering uncharted territory. Unlike past market cycles, there was always a Federal Reserve safety-net. Both in 1987 and 2008, when a market/economic/banking system collapse occurred, the Federal Reserve was able to quickly lower interest rates and provide liquidity to the market. This time with the markets reaching all time highs, they are doing so without a strong economy supporting them. Past market peaks occurred after extended periods of strong economic growth, and much higher and increasing interest rates, just the opposite of today. The reason markets are able to maintain such a level today is because interest rates are so low, not because real earnings and the economy are so strong. The broad market P/Es are near their averages, but we have near record low interest rates. In a health economy, interest rates this low would support a much higher multiple. If there is another market crash like 1987 or 2008, the Federal Reserve won't have anywhere near the fire power they had back in those previous crises. We are in uncharted territory for the modern Federal Reserve, and it remains to be seen if the Federal Reserve can effectively manage a crisis when their main tool, the Fed Funds' Rate, is effectively at 0%. I'm not sure the market has fully discounted that risk yet. The Fed would have to rely upon "unconventional measures," if a crash were to occur today, and those "unconventional measures" don't have a long track record to study. To get an objective measurement of the market's expectation of future growth one can use the Graham and Dodd matrix. With the AAA bond yield at 4.62%, current S&P 500 P/E of 17 and a forward P/E of 15, the Graham and Dodd matrix has the 5 year annual earnings growth at 5%. That is hardly a vote of confidence by the markets, and certainly not the foundation for a solid economic recovery.

5) Ironically, if the Fed's "Taper" does work, it could be a disaster, and trigger a crisis. By "work" I mean interest rates go higher. That isn't the goal of the "Taper," but is a possible/likely outcome. We have a very fragile economic recovery and a stock market reaching all time highs based upon all the wrong and artificial reasons. Higher interest rates could pull the rug out from under the recovery and stock market. As I said above, a P/E of 15 is sustainable with little real earnings growth if interest rates are very low, it is a whole other story to maintain a P/E of 15 with an economy teetering on a recession and interest rates headed higher. Simply use the Graham and Dodd matrix to see what happens when interest rates increase slightly when the markets are discounting 5% growth. A 6% AAA bond yield would drive the P/E down to 14.

6) To make matters worse, the WSJ has the current S&P 500 at 17 and the forward P/E at 15, expecting a 14% growth in earnings. According to the matrix a 4.62% AAA bond yield and 14% earnings growth rate would support a P/E in the upper 30's. The current rate is 1/2 that. Clearly the markets are seeing something they don't like.

For those reasons and many more, it is wise to develop an investment strategy that capitalizes on fear or at least manages it, instead of making you the victim of it. One useful tool to do that is the VIX index.

One way to use the VIX Index is as a hedging tool. If you are fully invested in S&P 500 equities, you can hold 10% of the portfolio in a VIX Index ETF. The time to buy the VIX Index ETF however isn't during a time of panic or market correction like we are having now, but instead, the time to buy the VIX Index ETF is during market euphoria, when the VIX Index is at a bottom. The objective is to buy the VIX Index ETF when things are good and the price of the VIX Index is very low, and then just wait, wait for the panic to hit. As your buy and hold stocks fall 10%, your VIX Index ETF should appreciate to offset some of if not all of the loss. Once the VIX Index reaches a level associated with past fear peaks and market bottoms, sell the VIX Index ETF and wait for euphoria to return to the markets and buy 10% in the VIX Index ETF again. This graphic shows how the VIX Index does a good job identifying market bottoms when it reaches certain peak levels. The S&P 500 and DJ 30 Indexes are the indexes compared to the VIX Index.

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This following chart shows how the strategy would have worked back in 2008. Over a period in late 2008, the S&P and DJ 30 lost around 25%. At one time during that sell-off, the VIX Index was up nearly 250%. A 10% holding in the VIX Index ETF could have nearly covered the 25% loss in the other 90% of the portfolio. The key is managing the fear. For this strategy to work, the VIX Index ETF has to be sold at the peak of fear to lock in the gains. The other thing that must happen is that the VIX Index ETF tightly tracks the VIX Index, something we will see later doesn't happen. The key, however, is the understanding that fear is only temporary, so the VIX Index ETF has to be sold into strength. Fortunately, from the above chart, the VIX Index has developed a pattern where reaching certain levels appear to represent good trading opportunities. The other aspect of this trade is patience. Once the VIX Index ETF is sold, that money has to remain in cash until fear subsides and the VIX Index returns to normal levels.

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On a shorter-term basis, we can look at how this strategy would have worked during the recent correction. With the S&P 500 recently reaching an all time high, market euphoria was reaching a peak, and the VIX Index was scraping along its bottom of around 12.

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Going back to 1990, the VIX Index never breaks 10, so by buying at 12 you have a good feel for the downside risk, which is about 20% if history holds and the VIX Index ETF tracks the index well.

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Assuming the S&P 500 reaching a peak triggered a purchase of the VIX Index ETF when the VIX Index was at 12, we can now examine what happened as the market rotated into this recent corrective phase.

After the market peaked, both the S&P 500 and DJ 30 fell about 5%, at the same time the VIX Index increased by 50%, once again, the 10% position in the VIX Index was adequate to hedge the other 90%...IF THE VIX INDEX IS SOLD TO LOCK IN THE GAINS. This is not a buy and hold strategy, this is an opportunistic strategy where you buy the VIX Index ETF when the VIX Index is between 10 and 12, and sell it into strength. If you wait too long, the gains in the VIX Index and ETF will evaporate and the opportunity to lock in the hedge gains will be gone. If you sell too early, the hedge will be lifted and you will be unprotected against further losses.

This technique is as much an art as it is a science, but then again so is hedging in general. What I like about this strategy versus a normal hedging strategy is that this strategy is on auto-pilot. If an investor goes home on Friday and returns to work on Monday with the Dow 30 down 500 points, the opportunity to hedge has likely passed. If however the investor had 10% in a VIX Index ETF in their portfolio on Friday and returned to work on Monday with Dow down 500, the VIX Index ETF would have automatically placed the hedge for the investor. It is a preset market driven hedge that springs to life in an emergency. It is like a hidden doomsday protection device in the portfolio, or like those invisible deflector shields that suddenly pop-up to protect alien spaceships in B-Movies from incoming attacks.

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With the VIX Index back up around the 18 level, and the Dow 30 currently down over 100, if I was implementing this strategy I would sit tight, but have a hair-trigger on the sell of the VIX Index ETF. The VIX Index is at an interesting level to trigger a sell and has covered essentially 100% of the recent losses of the portfolio, but as long as the market keeps correcting, I would wait for a few days of calm before I sold the VIX Index ETF. With the emerging markets correcting as much as they are, the recent events in Turkey, and the Fed's continuing "Taper," it might be prudent to wait until the VIX Index has created a peak and started to head south. Right now with the markets headed south and the VIX Index is still headed north, there is no rush to sell. You don't need to pick the peak, just capture as much of the hedge gain as possible. That being said, however, as I watch CNBC I notice that the markets are beginning to rebound, gold is actually down and the 10 year is below 2.7%. Those are the early signs I'd be looking for to signal the fear trade may be subsiding.

That in one use for the VIX Index, I call that investment strategy the Dr. Strangelove Strategy modeled off the old strategic military tactics of the cold war that inspired a movie of the same name. Like a strategic nuclear submarine placed off the coast of the former USSR that just patiently sits there until an external unforeseen event happens that triggers a pre-planned automatic defensive response. The 10% VIX Index holding just sits in the portfolio and goes nowhere for extended periods of time, creating a drag on the portfolio return worse than cash, but then "Ka-Pow," 2008 hits and the VIX Index hedge automatically springs into action like a reflex protecting the portfolio from losing the hard earned gains of the last decade.

One event like that will more than make up for the marginal underperformance the VIX Index ETF causes. It is essentially a quazi-insurance/hedge plan that costs the portfolio the market return on 10% of the portfolio plus the fund expense ratio and gain or loss. If you wanted to get fancy, you could also hold a leveraged index fund to maintain 100% equity exposure so the cost would only be the fund expense ratio and gain or loss. Here is a list of VIX ETFs. This article covers some practical issues investors should understand when using it as a hedge vehicle. The problem with theories like I've just defined above, is that reality sometimes doesn't meet expectations. As this graphic highlights, the VIX ETF doesn't do a great job tracking the VIX index. During the recent correction the VIX index gained 35%, whereas the iPath S&P 500 ST VIX ETF (NYSEARCA:VXX) only gained around 15%. Clearly tracking error must be worked into any long-term strategic investment strategy.

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The other problem is that unlike the VIX Index that tends to find a bottom between 10 and 12, the VIX Index ETFs that use futures face a "contango" problem, which results in them having an almost continual drowntrend except during panics.

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The above chart pretty much demonstrates why a buy and hold strategic position is not advisable, and that a strategy that buys low and sells into strength is necessary. A patient strategy of adding the VIX Index ETF only after it has corrected during a time of calm, and then selling it into rallies is the best approach to using the VIX Index ETF, but it leaves the portfolio unprotected for extended periods of time. Identifying seasonal patterns in the market's volatility may help in determining the most favorable period to hold a VIX Index ETF for protection. This chart shows how over the short-run the VIX Index ETF is in a down-trend the majority of the time, but there are frequent counter-trend rallies that offer opportunities to exit with a profit.

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Okay, let's assume you are an investor like me that didn't have the VIX Index holding in place before the market correction. The Dr. Strangelove Strategy came to me in my efforts to address the most recent correction. My securities have been hurt by the most recent correction, and I wanted to somehow try to minimize the damage done to my portfolio. All hope isn't lost. As the VIX Index chart demonstrates, the VIX Index tends to form a Saw type pattern consisting of long periods of inaction broken up by sudden spikes. The VIX Index tends to bottom between 10 and 12, and reach peaks near round numbers like 20, 30, 40 and has an all time high of 60.

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Because of the rapid peak forming behavior of the VIX Index, it allows for quasi-hedging after the fact. As the saying goes, "what goes up must come down," defines the VIX Index perfectly. The VIX Index isn't a trending index, it isn't like the S&P 500 where the expectations are that if you sit on it long enough it will eventually return to new highs. The VIX Index is like a street with road bumps in it. You are driving along nice and smooth, and then "bump" the car jumps momentarily, and then return back to street level. Right now the VIX Index is forming a peak or bump. Eventually, if history holds, the VIX Index will return to the street level of 10 to 12.

Investors can still capitalize on the fear driven sell-off after the fact by using the VIX Index. The VIX Index is not only a "fear gauge" but it is also a "return to normalcy" or "complacency gauge." There are two sided to every peak, the up side and the down side, so even though investors missed at least some of the upside hedging opportunity in this recent market sell off, there will eventually be a time when the VIX Index falls back to earth. To capitalize on the "inverse fear trade" when the markets return to normal, one can buy an inverse VIX fund like the iPath Inverse S&P 500 ST VIX (NYSEARCA:IVOP). Another way would be to buy puts on the long VIX Index ETF or calls on the inverse VIX Index ETF. Options and futures are also available on the VIX Index itself. Note however, a gain from 10 to 20 is a 100% gain, a fall from 20 to 10 is a 50% loss. That must be understood when using this ex-post facto strategy.

This is, however, more risky than the Dr. Strangelove Strategy. We don't know when the VIX has peaked until after the fact. If you buy the IVOP too early, not only will you continue to lose money on your portfolio, but you will also lose money on the IVOP holding. Because the VIX Index tends to bottom around 10 to 12, and the current VIX is around 18, it is possible that the IVOP losses will be reversed, but in the past the VIX Index has peaked as high as 60, so sizable losses can still be had even with the VIX Index trading at 20. That is why I think it is best to let the VIX Index peak and start heading south before implementing this strategy. You will never know for sure that the VIX has passed its peak when you place the trade, but buying it when it is headed south reduces that risk. There are of course no guarantees that it won't reverse itself, like this chart proves, head fakes and false reversals occur often. The key is, the VIX Index isn't a prefect hedging tool, the advantage it has is that it allows a hedge position to be placed, and the portfolio to continue to participate in the upside if the markets continue higher. The VIX Index hedge only happens if a rally is triggered in the VIX. While the VIX Index position will lose money while the markets rally, the loss will be limited to the weight it occupies in the portfolio.

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In conclusion: Looking forward, I would expect a volatile market as the economy adjusts to the transition from a monetary policy led recovery to a fiscal policy led recovery. I don't put much faith in a fiscal policy led recovery materializing in the near future unless every idea that has failed to work in the past for some reason starts working now. I've never read any text books that claim taxing, regulating, subsidizing and redistributing is a path to economic prosperity, recovery and growth. I thought that argument was settled with the fall of the Berlin Wall, but I was mistaken. Because I expect more of a trading than trending market going forward, I wanted to develop an investment strategy that manages fear and volatility.

That strategy is the Dr. Strangelove Strategy that at least theoretically provides some protection placed in advance to protect against sudden and unexpected bouts of volatility. The strategy is rather simple in concept, you simply hold 10% in a VIX Index ETF or similar security, but because there is as much art involved as science in determining when to buy and sell the VIX Index holding, the actual implementation is certainly more difficult than it appears. Investors interested in this strategy should fully understand the risks involved, the tracking error, hedging concepts, underlying securities being hedged, expenses and fully quantify and define a discipline before implementing this strategy.

For a strategy using the VIX Index ETFs to be successful, a model must be designed that keeps the portfolio exposed to the market the majority of the time to avoid the losses in the VIX Index ETF, but tactically adds the VIX Index ETF in advance of expected volatility. The VIX Index ETF then needs to be sold into the strength. If a panic does occur during an uncovered period, short VIX Index ETF and options provide a way to place the hedge ex-post facto. Because hedging strategies are unique to the portfolio being hedged, I deliberately did not provide a quantified trading system for that reason. The purpose of this article wasn't to provide an answer, but to instead discuss possible approaches that could be combined into a successful VIX Index portfolio risk management model.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Full Disclaimer and Disclosure Click Here.

Source: VIX: How I Learned To Stop Worrying And Love The Fear

Additional disclosure: Depending on how this market progresses I may buy a short VIX ETF in the near future, or calls on the short VIX ETF. I have no definitive plans to do so right now.