Fear vs. Greed - Who knows what's coming?
The CBOE Volatility Index (VIX) has a long history (back to 1990) of calculating the implied volatility of the S&P 500 Index of stocks, based on the close-to-the-money prices paid for near-expiration options on the S&P 500 Index. The VIX index measures the uncertainty component of the standard formula for pricing options by turning that formula around and taking market prices as an input (instead of solving for them) and instead, solving for an uncertainty amount that would justify the then present options market prices.
Uncertainty is an essential part of evaluating the appropriate prices of options, because the bet embedded in the options contract magnifies the return (positive or negative) on investment made in the purchase of the option. Greater uncertainty magnifies the value and probable cost of the contract, as it magnifies the future price possibilities involved.
But uncertainty is bi-directional, quite different from risk, which is uni-directional, depending on the posture taken by the investor in the particular venture. The mathematics involved in calculating the uncertainty cannot determine likely direction of price movements.
What does provide some sense of order here is human nature. Human nature is to dislike uncertainty, and it values a sense of order and predictability. When uncertainty increases, humans seek protection from harm, and in the investment world, that always has a cost. So with higher uncertainty, there will be higher prices for protection. Paradoxically, for the typical "long" investor, the protection being sought is from lower prices on his invested capital. Investment prices going down make uncertainty prices go up.
Here is a look at how the VIX index and the S&P 500 index have behaved over the past 5 years:
Declines in the S&P cause rises in the VIX. Stock prices are the initiator, the VIX is the reactor. For that reason, trying to use the VIX as a forecaster is futile. This picture shows how movement in the VIX Index (in blue) is much more volatile than movements in the stock index (in green). There is no exchange market where direct bets can be made in the VIX Index.
But there are futures markets where bets about coming VIX index prices can be made in a disciplined and orderly way. Such futures contracts, derivatives themselves, also have derivative securities in the form of options and ETFs holding futures and/or options.
Investors and speculators express their beliefs about coming values of these derivative securities in the prices paid in transactions involving the securities. Where there are options on the futures or the ETFs, it is possible to derive implied forecasts of the index value of the VIX, but all effective transactions are in the derivatives, not in the index. The VIX index itself remains the passive result of derivative transactions in the index options.
But the resulting index is a legitimate expression of the extent of investor concerns about price changes. So it becomes part of the investing scene and an object of speculation itself. Its inherent volatility has attraction for hedging transactions. The measure of the presence of price risk becomes a means of its (risk) mollification.
Since the basic reaction of the VIX index to price is inverse, efforts to gain capital value from the index's rise implies a focus on stock price decline. With stock prices in a rising mode 3/4ths to 7/8ths of the time, there is an overwhelming bias to the downside of most VIX derivatives. This makes the prevalent approach to using them take on a "short" posture, one not available or desirable to many investing operations.
Here is a picture of how the VIX index (in red) and many VIX derivatives have trended over the past 5 years in comparison to the S&P 500 stock index (in yellow):
The lone rising VIX security, the blue line, is the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY). Being a short of an instrument that functions inversely to stock prices puts it back on the same functional side as stocks themselves. It has only been in existence for about half of the pictured period. Its functional opposite is ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY), coming into being at the same time.
The operational leverages of SVXY and UVXY in relation to the VIX index make any kind of structural leverage augmentation unnecessary. But as can be seen from the S&P's approximate doubling since the SVXY's introduction and that ETF's 600+% rise in the same period, these two ETFs have at least the equivalence of a 3x structural leverage.
As has been explained in many SA articles on short leveraged ETFs, the existence of price differentials based on contract expiration dates in futures markets seriously aggravates price progress through time. That is painfully apparent in UVXY, and the inverse effect is a part of the substantial gains of SVXY.
Current stock price changes and their impact on the VIX and its derivatives
Thursday's -2% decline in stock prices put a predictable jolt into the VIX community. First, let's look at how daily VIX index prices have trended over the past 6 months and what the MM hedging activities have implied as to coming change possibilities:
(used with permission)
Brief stock pullbacks in March and April caused minor VIX perturbations, but the index's price (the heavy dots) continued to erode through June as S&P 500 index prices (not pictured) rose. Market maker [MM] price range expectations, the vertical lines in the picture, followed the VIX index down until July, when they started to firm up along with index prices.
Then, on Thursday, the market's -2% break in price was dramatically reflected in the VIX index's rise from about 13 to 17, a better-than-25% one-day gain. The gain held on Friday, with hedgers' forecasts of a further +39% gain potential compared to a possible setback to 15, a -13% drawdown.
The current hedgers' forecast has 22% of its full forecast range of $15.08 to $23.74 below the end-of-day price of $17.03, so its Range Index now is 22. In the prior 120 days' experiences of having Range Indexes of 22, the VIX in its next 3 months encountered worst-case drawdowns averaging -19.4%, somewhat worse than the present forecast.
Following our standard time-efficient risk management, discipline gains were achieved in 60% of the 120 cases of a 22 Range Index in the past 5 years, not a very satisfactory history. Gains would have been scored by reaching the top of the forecast range, or failing that, in 3 months after the forecast, being then at a price above the position's cost. Costs for such hypothetical positions are taken at end-of-day price on the day after the forecast. Average gains achieved, net of losses (the other 40% of the 120), were but +9.6% of costs. Not a very attractive payoff for putting capital at risk with exposures of twice as large as the average gains.
But all of these measures are nominal for the VIX, since it cannot be invested in directly.
Instead, when we look at the VIX-related ETF with the longest history, the iPath S&P500 VIX Short-Term Futures ETN (NYSEARCA:VXX), here is what its forecast history and risk-discipline experiences show:
Its Range Index of 32 has a less favorable upside-to-downside than the VIX's 22, and offers less upside promise of only +31%. Further, larger drawdown experiences of -27% are pretty scary, almost as large as the upside. Besides, the actual history of price changes in VXX after 458 prior RIs, nearly half of its 4-year daily experience, has been a horrible -18% loss in typical holding periods of 2½ months. Annualized, they would be at a worse than -50% loss rate. The odds of a win have been 15 out of 100. Pretty ugly.
But not much of a surprise if you go back and look at the gold-colored line in the second picture of this article. The negative effects of rolling over 1-month futures contracts in a typically dwindling-value underlier are nearly certain to be devastating, except for very short holding periods.
Like, did you happen to own the VXX on Wednesday and sell it out at the close on Friday? You would have made 13½% in the two days. Hooray! But that would have vaporized quickly if you had been in any of the 458 prior -18% losses.
Here are recent histories of the VIXM and UVXY alternative VIX ETF "investment" vehicles. Sadly, they are representative of a number of others.
Well, maybe the thing to do is sell these VIX ETF losers short.
There are a number of things wrong with that strategy.
- The bias against VIX ETFs is well-known, so almost any shorting deal you can arrange is likely to leave you with either lousy odds for a gain, or a trivial payoff for the risk you undertake. The "other side of the trade" sees you coming.
- These are not high-volume-of-trading instruments, and the ETFs are hard to borrow so that they can be sold short. The likelihood of a short "squeeze" may be high.
- Any time you sell something short, part of what you get paid for in the sale is your ability to control the timing of actions in the transaction. That is because the lender of the asset you have borrowed to sell retains the right to demand its return at any time of his choosing. You can bet that his timing is likely to be your worst.
- Besides, all you can make is 100% of what you get paid; all you can lose is whatever you are forced to pay to get back what you sold, which can be multiples of what you sold it for.
The only VIX instrument that, from the start, is structured to take advantage of the peculiar characteristics of the VIX Index is the ProShares Short Vix Short Term Futures ETF. And its advantages are getting increasingly well-known. That makes it harder and harder to find moments when it will offer competitive returns in exchange for the risks involved. Let's take right now, for example:
Current hedging of SVXY reflects the market's current drop. A week and a day ago, the SVXY RI was 64, a forecast of nearly twice as much downside as upside. Its low-end forecast was $73.90, right about where it is priced now, at $74. But is its RI now zero? No, the RI is 29, because its forecasts have declined along with its price.
The last time SVXY's RI was 29-30, its price was $62-$63, -8% to -9% below its current low-end forecast. The highs of its forecast then were a couple of points below where the market quotes are now. Today's upside forecast is some +20% higher - from here, +30% from the low $60s. Can it happen?
Sure, it can. The past 29 RIs have made profits in 7 out of ten tries. That's ok, but we like to see 7 out of 8 (87/100) history to justify a new position. And the net wins to-date on RIs of 29 have been +11%, not the +20% being projected. Credibility in question? Maybe better to wait out a new commitment just now and see what may take shape.
Comparing bets based directly on the VIX Index's moves to those on its inverse
A few Seeking Alpha observers have noted that short-structured ETFs, particularly leveraged ones, have registered encouraging gains in the past week or two. The market drop this past week and the rise in the VIX have provided encouragement for that game.
Unfortunately, MM talents in identifying coming gains in the VIX Index have not been very encouraging. When we apply our standard time-efficient risk discipline test to all available VIX forecasts, their subsequent profitability bears poor relationship to the Range Indexes of the forecasts. Here, those test profitabilities are represented by 1 + the decimal percentage gain or loss involved. Anything less than 1.00 is a loss.
The time period covered here goes back to early 2006, so it includes the period of the MBS financial calamity in 2008-2009 up to the present. Not much forecasting advantage in the VIX is evident, with nearly as much loss experience as gains, regardless of the upside-to downside balance prospects in each Range Index.
Can't these best of professional observers do better in making VIX-related forecasts? Not if they try to use the VIX as a forecaster of coming market declines, for many of the reasons explored above. But when MM forecasts are directed to shorting VIX futures instead of being long VIX futures, then we see a very different picture. Here is the scatter of all SVXY Range Indexes and their Time-Efficient Risk Discipline outcomes:
Fully 89% of these forecasts, regardless of Range Index, produced profits. But, of course, the market was advancing much of SVXY's lifetime. To make a fair comparison, we need to look at the VIX over the same period:
This does show that the MMs have better foresight for the VIX when their Range Indexes are negative (current price below the forecast range) than when their forecasts see any downside possible. Overall, bets on the VIX, regardless of their RI forecasts, came up as being profitable only 68% of the time. That's a 2-wins-out-of-every-3 record.
The SVXY's win odds on the same basis are 89%, or about 8 out of 9. Out of 9 bets, the VIX wins only 6.
Making guesses about the market's direction of price change, when it will happen, and how far it will go is harder than hitting for the cycle in Major League Baseball. (In one game, one hitter getting a single, a double, a triple, and a home run).
Even if there are lots more folks in the market trying to do it.
There are too many moving parts, loose linkages, and factual noise interferences.
Worse yet, the outcomes are products of human perceptions, from diverse global and political perspectives, operating under conditions of communication contagion for emphasis, where misinformation and disinformation are unavoidably part of various game strategies.
But there are many players out there reaching to grab just a brass ring this time around, even if they don't get the gold one. (Some of those players already have the gold ring in the form of their MM jobs.)
The VIX index tells what has happened to uncertainty, not what will happen to uncertainty next. It does not tell what is likely to happen to stock prices until it gets to heights where past experience has been recovery in stock prices - soon, but not reliably by any predictable amount, or how quickly.
Great stuff to talk about, to confuse investors with, but not much to make money on - reliably. Unless you find investors with enough sophistication to know what really is at stake and who are quick and confident enough to be betting against "the fear index" at the right times.
Over 3 million SVXY shares traded on Friday, five times the average daily volume.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.