Speculation Provides A Surge For Volatility

| About: ProShares Ultra (UVXY)

Summary

My advice of not chasing the short volatility trade has proved to be correct.

The rising risk of a Brexit is spooking the volatility markets.

The overall market still has a ways to fall should things turn south.

Hello everyone, I am currently at a teacher conference but wanted to post a quick update given the surge in volatility.

Let me first start by saying, patience is a virtue. I posted a month ago about the risks of shorting volatility at current levels. I received some flak but stuck to my original recommendation. There isn't ever a reason to chase volatility trades. A trend is one thing. Missing an opportunity and trying to make something out of nothing is another. Hopefully my advice saved someone a large amount of capital.

Let's take a look at the last month for ProShares Ultra VIX Short-Term Futures (NYSEARCA:UVXY).

By shorting UVXY after I recommended caution you could have made a theoretical 25% gain. However, all of those gains would have dissipated in the last week. I again reaffirmed my position on June 6th with the intent of encouraging people not to chase trades and avoid the risk of a short volatility position.

In May I offered some potential events that could cause an uptick in volatility. One of those events was the European risk from a possible Brexit vote. The current polls have shown that it might be a possibility.

As a response, investors are purchasing protection which has driven the VIX up significantly. See below for a comparison between the S&P and the VIX:

In the past five trading days the market is only down 1.42%, yet the VIX Index has surged 53.6% with additional gains after hours.

Contango, which aids in the decay of UVXY, has almost disappeared.

Click to enlarge

Fear

In addition to the European risks of a Brexit, more economists and big banks, such as J.P. Morgan (NYSE:JPM), have come out and predicted that the risks of recession within the next 12 months are extremely high. Some of these same banks also predicted a melt up in the market.

These recessionary fears are aiding the melt up in volatility. With the market near all-time highs, purchasing protection through volatility rather than selling stocks seems to be the trade of choice for the market.

Another statement I made in May was the possibility of slowing employment in the U.S. When the May jobs report came out, it was beyond disappointing. One month does not mark a trend, and the API report has a much different take, but this bears watching.

If the labor market begins to weaken the risk of recession is very high. We are barely moving the inflation needle as it is.

My Plans

I am going to begin shopping for trades in volatility next week. Given current conditions I don't feel an all in short volatility trade is appropriate but I may begin to buy Puts on UVXY that are between 1 and 6 months out. The Brexit vote will take place on June 23 rd. I don't believe I will do much trading before then unless volatility rises significantly from here.

The downside of selling Puts now is that you may lose 100% of your trade. The upside could be that those Puts increase in value several hundred percent. See my recent article on bet sizing for a better explanation and thoughts on win rates and expected values.

Other Thoughts

The Fed is caught between a rock and a hard place. My guess is that they will not act until after the Brexit vote. If labor market conditions begin to worsen expect rates to remain unchanged. The only sector really hurt by low rates are financials. Everyone else benefits, plus the banks are negatively percieved, so it is an easy decision for the Feds to make. However, eventually this experiment of QE to infinity will have to end. It would be nice for it to end sooner rather than later with positive economic conditions.

We have talked before about how the Fed has single handedly been a volatility trader's best friend over the last 5 years. We know that Fed policy will likely remain the same until January when a new administration is sworn in. All one needs to do is look at a volatility chart over the past 5 years in relation to global central bank actions. Manufactured growth is the new organic growth, where it stops no one knows.

Conclusion

The market is entering very interesting territory but there isn't blood in the streets, yet. Current economic conditions remain slightly positive. Economics drives the reversion in the VIX. A reversion to 17 will not produce the same results as the previous reversion to 13.

Volatility has risen in anticipation of events that haven't happened. This is creating an opportunity to short volatility if conditions worsen and the economic outlook remains positive. However, the market still has a ways it could fall from here and there are plenty of global growth fears to keep a lid on gains for now.

As always, I encourage you to list your thoughts below and have a professional discussion about the types of trades you may be looking into (long or short).

I hope you have a very profitable rest of the week. If anything else significant happens, we'll talk again soon.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in UVXY over the next 72 hours.

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.

Additional disclosure: Short UVXY may also be substituted with long XIV.