As the European debt situation stabilizes, the market will become less volatile as investor fears are allayed. This will result in a decline in the volatility index, VIX, and I believe that this unwinding could occur very soon.
Times of economic normalcy are marked by a VIX below 20. Times of economic stress are typically signaled by a move in the VIX over 30 with extreme duress (such as in 2008) marked by sharp spikes at much higher values.
For the past several months, the VIX has been oscillating between 30 and 45. It has only been in the past few days that the VIX has crossed below 30. If it can close below that level for a couple of days, that would be a compelling signal that the volatility bubble is starting to deflate.
Futures traders can easily short the VIX, but what if you’re not into futures or options? The inverse VIX exchange-traded note, XIV, offers an attractive solution. The chart below shows that the XIV is rebounding off its October 4 low. Because XIV is a futures-based product, it’s subject to rollover issues, and like leveraged exchange-traded products, XIV is reset on a daily basis. On top of that, the fund has only been around for less than a year. These peculiarities make direct comparison with the VIX difficult, but the charts below depict the general relationship.
The first half of this year saw the VIX ranging mainly between 15 and 20. In that time, the XIV was steadily increasing. It reached its peak of 19 in July when the VIX was at its lowest point of 15. Now does this mean that we can expect XIV to return to that level should the VIX fall back to 15? I honestly can’t say. Based on the 50% drop in the VIX last March where the XIV concurrently rose 45%, it’s not unreasonable to expect XIV to at least reach the $7-$8 range, which I feel is a conservative estimate.
The major downside with this trade is if the VIX remains stubbornly high, as it has been doing. This could cause further price erosion in XIV due to its nature, so if you’re going to trade this, it would be wise to use a stop. Otherwise, why not risk a little mad money on risk itself?
Note: XIV is very actively traded with an average daily volume of over 8 million shares. It does not trade options.
Disclosure: I am long the XIV.