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Summary

  • VIX futures ETPs have become extremely popular and investors are increasingly on the short side of the trade.
  • This strategy works when the trade is not too crowded and the market is moving from fear to calm.
  • Now the market is complacent and investors are in a bidding war to sell "market insurance."
  • Unless investors are willing and able to engage in relative value strategeis in the VIX space, it is time for shorts to get out and reduce risk.

A trade can be good if it involves securities that are unpopular and cheap but terrible if it involves securities that are too popular and expensive. This article argues that short VIX futures, such as the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV), VelocityShares Daily Inverse VIX Medium-Term ETN (NASDAQ:ZIV), and ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY), have become too popular and shorts should get out while the going is still relatively good.

The basic appeal of short VIX futures securities is pretty simple. They have done extremely well in the recent past:

XIV Chart

XIV data by YCharts

Two main factors contributed to this eye-popping performance in recent years. First, the VIX has dramatically declined since the end of 2011, fueling the returns of investors with a short position in VIX futures. The VIX reflects the price investors are willing to pay for S&P 500 options (SPX options) that expire one month into the future. Pundits call the VIX a "fear gauge" because it reflects in part the cost of put options that serve as an "insurance" against market declines. Second, VIX futures have been in steep contango for much of the period, meaning that contracts further out in time are more expensive. When products that maintain the same maturity such as XIV rebalance into these more distant contracts, shorts roll their positions for a gain. This explains why short VIX futures ETPs have done much better than the VIX and also why long VIX ETPs such as the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) have done much worse than the VIX over time:

XIV Chart

XIV data by YCharts

The problem is that many long VIX futures speculators seem to have capitulated. Now only market makers, institutional investors seeking true hedges, and long-short funds are on the long side. The flood of retail "dumb money" into the long side has slowed to a trickle, starving the growing pool of shorts looking for prey.

The recent crisis in Ukraine is a case in point. In recent times, backing up the truck for short VIX futures positions in the middle of a market scare has been extremely profitable. There's been no shortage of short-term fear events: the Greek election in summer 2012, Cyprus bailout in Spring 2013, China's credit seize-up in Summer 2013, and various fiscal scares manufactured by Washington. Every time this happens, more investors take a short VIX futures position. And shorts have been rewarded handsomely, often pocketing 30% or more in a month.

Not surprisingly, everyone wants in on this. But the very popularity of the trade reduces the contango and dampens any spike in the VIX. This means that when markets switch back to risk-on mode after a brief hiatus, the gains from a short VIX position have declined and the bet has become increasingly risky.

As Russian troops entered the Crimea late last week, the VIX futures market barely shrugged. Front month contracts jumped up a bit, but further out contracts hardly registered any movement. This is the classic sign of a complacent market: "everyone knows" that a certain event will blow over soon and there is no need for downside protection into the more distant future.

This is an extremely dangerous place for VIX shorts because their risk-reward payoff is similar to a highly leveraged S&P 500 futures position. When we finally get out of bull market mode, VIX shorts will feel the pain of leverage just like in 2011:

XIV Chart

XIV data by YCharts

When the market does not recover quickly, VIX shorts are washed out to sea. It is only a matter of time now.

Conclusion

In summary, I like the idea of a short VIX futures position. Selling market insurance when investors are panicky seems like a good business. But when investors are complacent and insurers are engaged in a price war, it is time to get out of business. If you are unwilling or unable to employ relative value strategies (many investors using ETPs are not), then close out your position and move along to another strategy for the time being. The trade is way too crowded right now. Personally, I'm sitting on cash and waiting for a washout: I suspect that the market insurance business will be in better shape in the not-too-distant future.

Source: VIX Shorts, Look Out Below