Markets continue their unpleasant grind. We're still going higher, but it's in a choppy listless manner that leaves all but the nimblest day trader on edge. The market continues pushing up, but with sizable quick dips.
Every rally is faded, as bears continue to try to force a top around here. The normal correlations we'd been watching - oil (NYSEARCA:USO), the yen (NYSEARCA:FXY) and so on aren't really working that well now. On Wednesday, for example, oil shook off a big morning dip to surge to multi-month highs. The S&P 500 (NYSEARCA:SPY) put in a mild morning rally before fading to flat, despite the huge oil stimulus.
The S&P 500 is now within 25 points of making meaningful new highs. But the bears are apparently not going to cede the last few points without a fight.
As discussed earlier this week, earnings are the main risk to market upside. They are putting a damper on what's otherwise been a pretty solid set of developments in areas such as oil and emerging markets. Qualcomm (NASDAQ:QCOM), Kinder Morgan (NYSE:KMI), and Las Vegas Sands (NYSE:LVS) headed a pretty sizable list of earnings disappointments for Wednesday.
For anyone other than short-term traders, there's not a lot to be done here. Either the market is going to break to new highs, or there will be a steep correction starting from right around here. I've taken some gains off the table, but other than that, it's time to wait and see. In one market in particular, I urge great caution.
The money flows and trading activity in volatility recently make me concerned that some people are about to lose a lot of money speculating in a thing they don't fully understand.
Back and Forth, Volatility Is Elevated
Things are getting pretty crazy in volatility-land. The VIX-based volatility ETFs VXX, UVXY, TVIX have been experiencing wild swings to start the week. It's part of what may be becoming a broader trend worth watching.
These moves are outsized, based on what you'd expect given the actual size of swings in the S&P 500 and other broad indices.
On Tuesday, a meaningless 0.5% move in the S&P 500 unleashed a bizarre 5% rip higher in the VXX, a move three times as powerful as you'd generally expect given that level of market movement.
Monday's VXX plunge from 17.10 to 15.80 was also rather extreme given the moderate size of the S&P 500 move. UVXY, the 2x levered version of VXX, has had a nauseating week:
UVXY Price data by YCharts
I'm not the only one noticing this. Astute market commentator Peter Tchir wrote:
[Monday] was a strange day indeed. VIX dropped 2% but VXX dropped 6.3%. I took a look at all days since 2014 when VIX was lower on the day. This underperformance of 4.3% was the second worst underperformance. The only time that VXX did worse relative to VIX on a down VIX day was October 19th 2015 [...]
UVXY was down 12.7% yesterday and TVIX was down 12.3%. The S&P 500 was up 13.6 points or 0.65%. That seems like an extreme hedge ratio of around 19:1.
I've been watching VXX products on a daily basis for almost four years now. They're one of my top signs that the market may be coiling toward some sort of big event. If VXX is any guide, there's a lot of hot money trying to catch the next big trend - which it views as imminent - and it's starting to feed on itself.
I'm generally against going long volatility. It's a poor "hedge", in the sense that simply shorting the SPY ETF or buying S&P 500 puts usually has a better return profile than buying VXX or its related products. VXX has a truly horrendous track record:
VXX data by YCharts
While shorting the S&P 500 or buying rolling short-term puts on the market would have lost gobs of money over the past 7 years, these strategies would have still preserved more of your capital than buying volatility.
The contango effect in the VIX market makes this a very dangerous place to park money, since your capital erodes so rapidly for every day and week that your desired market breakdown doesn't occur.
With contango currently at 9% on a monthly basis - assuming 20 trading days per month - you're losing 0.45% of VXX's value every single trading day to contango. With UVXY, you lose almost a percent a day. That's almost impossible to overcome if you don't time the correction just right.
In addition, this is a bad time to buy volatility, because the trade is so popular. Remarkably, since mid-February, more than $1 billion of new capital has been "invested" in UVXY. As of the most recent data, UVXY only has about $850 million left in assets.
It's pretty remarkable, all the legacy shares of UVXY created and not redeemed since inception plus the newly created $1 billion in shares early this year are already - combined - worth a substantial haircut to merely the latest group of speculators' bets.
The retail appetite for volatility forces prices of it up higher than they'd otherwise be. Without a billion new dollars recently coming into UVXY, VIX prices would almost certainly be significantly lower yet than they are today.
What that means is that should the rally continue and push up over 2,150, volatility longs are set to take another huge pounding as VIX returns to unthinkably low levels.
On the other side, it's also a dangerous time to be short VIX products. Given the amount of beta that VXX has to the S&P 500 at the moment, VXX could easily spike 30% or 40% on a 5% market decline - just back to 2,000 - and send UVXY up for a clean double.
Volatility is a very hot market at the moment, with many folks playing for either a dramatic market breakdown or an equally memorable collapse in volatility as the market pushes to new all-time highs.
If you're trading it short-term for speculation, or you're trading it with a short bias to profit from contango, be very careful. These are the sorts of waters that inevitably lead to trader blow-ups when a vicious 50% move up or down occurs in a couple of weeks.
The risk of shorting is clear, but let me remind longs that volatility can go a lot lower in a week or two if the market makes new all-time highs. A single-digit UVXY reading by June is fully in play now if the market breaks higher.
An unfathomable sum of money has been lost buying UVXY because it's "cheap" and VIX "has to go up" after it becomes depressed following big market rallies. Due to contango and the busted nature of the volatility ETFs, what goes down doesn't have to go up in this case.
I retain my permanent short position in UVXY, but it's a very small portion of my funds. If UVXY quintuples on up to 75 on the next market correction, I'll still have a large profit and sleep well at night. I'm normally short additional quantities of VXX for shorter-term trades. However, in difficult markets, I take the VXX ship into port to wait out the storm. I currently have no VXX position.
Disclosure: I am/we are short UVXY.
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.