A Once In Few Years Opportunity Presents Itself

| About: iPath S&P (VXX)


Market complacency is at multi-year lows.

As measured by the XIV, numerous short volatility trades are likely in place.

A Long Position in the VXX appears to be very asymmetric.

The VXX is an ETN designed to provide investors with exposure to front month futures of the S&P 500 volatility index. VXX first began trading in January 2009 but history for its benchmark is available since December 2005. Had VXX been around in 2005, a $1,000 investment would now be worth under $9.50. That's not a typo: an investor would have lost 99.5% of his money.

Likewise, XIV is designed to provide the inverse return of the VXX. A $1,000 investment in late 2005 would be worth just under $4,000 today. Even more impressive, owners of XIV have seen a gravy train, with a 500% gain since 2012. This is in large part due to the Federal Reserve's policies of financial repression.

Given the data points I have presented, a reader could logically conclude that shorting volatility is the better "buy and hold" investment.

Irrespective of the Fed's desperate attempts to manipulate market participant behavior and create the proverbial free lunch, with respect to market volatility, I believe that they cannot change the basic rules of speculation...

"What the market giveth, the market must taketh..."

Every few years there have been terrifying spikes in volatility, which have wiped out much of the past profits of vol sellers. In the financial crisis for instance, an investor would have seen an investment in the XIV (had it been around) plummet 90% from peak to trough. Even as recently as 2011, we saw the XIV actually lose two-thirds of its value in just weeks.

But the past 2+ years have seen no such events but instead have seen an amazing level of complacency - eerily similar to the period between 2005-2007.

There are several market phenomena that occur prior to major market corrections, some of which are currently present. As such, I believe we could be entering one of those once in few years 2+ sigma volatility spikes and investors would be wise to cash in their chips and swap their long XIV for a long VXX posture.

Reason 1

Recently, there has been a subtle but important change to the vol curve. It appears volatility has been trading at a hard floor. I come to this conclusion by looking at the VXX versus the VXZ. This is essentially a ratio of short-term futures performance versus intermediate term. You can see that VXX (the ETF that has lost 99.5% of its value since 2005) has stopped falling relative to longer dated futures. It is rare for the three-month rate of change of VXX to surpass VXZ and it has been a necessary condition that preceded/coincided with major market corrections since my dataset began and supplemented by my observations over the past 20 years of investing.

Pull up a chart of the absolute value of VXX and you'll also see that it has stopped making new lows. The implications are tremendous. Low levels of VIX coupled with very inexpensive contango costs makes owning short-term vol as attractive as it can ever be. This is not an opinion, it's financial math. I am not saying that owning VXX today will be a profitable trade; rather, if you're ever going to own it, these are the conditions you'd want to own it in.

Reason 2

The 3-month rate of change of the XIV has gone negative. Some people may argue this is the same as reason 1, but I argue that it isn't. It's possible to have rising vol in a contango. Such a situation would make both XIV and VXX a poor risk/reward trade, but it's not the situation today.

In summary, a lack of profitability in shorting volatility incentivizes investors to cover shorts. These short vol trades have accumulated in over 2 years of market complacency and are in all probability quite substantial. Using past major market corrections, such as 1998 and 2011 as a template, there is no reason to believe the XIV couldn't trade down to 15 or below.

Reason 3

Most traders of volatility don't use inter-market analysis to supplement their views. They rely purely on the technical factors to create their views. For instance, investors may have looked at only the XIV last summer and concluded that they should purchase VXX. They have looked at VXX:VXZ at the end of 2012 and thought the market was in trouble. However, looking at stocks versus bonds as an additional filter would have created a correct conclusion that equities were still the favored asset class in 2013 and hence an investor's best trade was to do nothing.

April 2014 tells a much different story, as we see momentum has broken in stocks versus high yield bonds. This is an event that has occurred in prior market corrections.

The Good News

There is some good news though. Major market crashes should be preceded by a widening of credit spreads below their levels of six months prior. This is not the case today though spreads wouldn't need to increase substantially to hit that marker.


Low levels of market volatility and little contango make hedging/owning volatility less of a cost center today than any time since 2011. In addition, the near free lunch sellers of volatility have had for over 2 years is close to unprecedented in market history. My gut tells me that many professionals are explicitly or implicitly over-leveraged in various short volatility manifestations such as carry trades, selling puts, use of margin debt, etc.

Much of this has been due to the Fed put and explicit policy of financial repression. It is my theory that the Fed is swapping complacency today for much more dangerous conditions in the future. Any number of global events can trigger a horrific unwind such as a Russian invasion into Ukraine or an emerging markets crash.

While I would have preferred much weaker credit conditions as a precursor to be long VXX, the long vol trade is as asymmetric as I have seen it in years and I have personally made a very big bet relative to my net worth that we will see much higher levels of volatility in the summer of 2014.

Disclosure: I am long VXX. 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.