Betting Long UVXY On Scottish Referendum

| About: ProShares Ultra (UVXY)

Summary

Scotland is likely to vote to leave Britain, it is the only outcome I see.

But it might be obvious for the markets in advance, so they could fall insignificantly.

Volatility will probably rise, but it failed to do so in 20% cases.

Watch market reaction on Scottish referendum announcement as a guidance of its reaction to referendum itself.

Introduction. After Brexit, talks about Scotland leaving UK started to sound strong again. No wonder Scottish first minister offered to hold referendum. Let us have a deeper look at it.

Scotland after Brexit. Unlike 2014 Independence Referendum, Scotland's chances of winning the next one are higher than ever before. Let's have a look at numbers: back in 2014 they voted 55/45 to stay inside the UK. Brexit messes it all up.

British vote by county map Click to enlarge

(SOURCE: BBC).

I think I do not need any other map to find the border between England and Scotland. Details county-by-county analysis is also not necessary, as the map clearly says it louder than any words would.

It is not a historical Scottish desire to leave. There is an important point to understand about British internal and external affairs. Playing with Euroscepticism has been a long and interesting game among British politicians. Actually, the mood against Continental Europe (what a wonderful name, which only the British can invent) has even longer tradition:

"For four hundred years the foreign policy of England has been to oppose the strongest, …, most dominating Power on the Continent….Here is the wonderful unconscious tradition of British foreign policy. All our thoughts rest in that tradition today."

Part I. The Gathering Storm. The World War II by Winston Churchill.

Margaret Thatcher, well known for her dislike of United Europe, has been frequently warned by her colleagues that the nations comprising UK might make the same move. It was all about "If Britain can separate from Europe, why can't we, Scotland, be on our own".

Now the matter is different. Scottish seeking for independence is about their wish to stay in the EU, which is desired by 62% of its citizens. Almost two thirds. And Nicola Sturgeon, First Minister of Scotland got the public mood right and raised the question of another referendum for independence.

Possible outcomes of vote. However, it is not that simple that all those two thirds EU fans will vote for Scotland's independence. Actually this is just one marginal case (in which 62% would vote to leave the UK). The other marginal case is that UK/Non-UK and EU/non-EU are two completely different, non-intersecting categories. In this case UK vote (from 2014 referendum) will lose its EU fraction voters, so the number of "remain in the UK" for new referendum in Scotland can be forecasted at 55%*0.38=20.9%. The truth is somewhere in between.

The above conclusions are very approximate and it is not reasonable to rely on them alone. What is more important that among those 38%, who voted to leave the EU the opinion will change. We all see what is going on inside Britain, there is already massive disappointment in Brexit, and I forecast that it is going to be even more.

Overall, the only scenario I see is Scotland leaving UK, if the new referendum is held.

UVXY and betting on Scotland's leave. Once the date is set, it is reasonable to prepare to short S&P (NYSEARCA: SPY) one way or the other. However, one needs to watch carefully whether markets are confident that Scotland would leave before that happens. For example, UVXY (NYSEARCA: UVXY), a double long bet on VIX volatility index, soared from 10 to 15. Long UVXY calls offer even higher return, approaching 25x. Of course, it is not that simple because contango deteriorates long UVXY returns, but holding it for no more than 1-2 weeks pays back well if you got it right.

Brexit's outcome was unexpected, but I think it is going to be more certain about Scotland. Therefore, we should remember that sometimes when markets go down, UVXY does not rise accordingly (as it should).

Days between SPY observations of negative returns

1

10

20

30

40

50

100

200

Probability of UVXY negative ("bad") returns

20%

18%

11%

14%

16%

17%

16%

14%

Click to enlarge

So, allow 20% possibility that your UVXY long bet will fail, even if you are right about "leave" vote outcome and plunging markets. The actual size of this fall will depend on market's surprise. I designed a table to help you understand your possible long UVXY return based on that S&P fall.

days between SPY observations

5

10

30

50

70

99

SPY decline

1%

101%

97%

83%

84%

66%

58%

2%

110%

107%

95%

85%

72%

68%

3%

118%

118%

113%

89%

79%

81%

4%

131%

129%

115%

85%

82%

93%

5%

139%

157%

123%

109%

101%

91%

6%

153%

149%

132%

120%

104%

100%

7%

204%

184%

172%

127%

127%

102%

8%

n/a

169%

185%

159%

146%

118%

9%

n/a

254%

166%

157%

152%

125%

10%

226%

234%

201%

196%

183%

108%

11%

257%

249%

225%

171%

162%

n/a

12%

n/a

n/a

211%

201%

181%

129%

13%

n/a

n/a

n/a

216%

206%

n/a

Click to enlarge

Average historic return on long UVXY position depending on historical SPY decline (rows) and number of days at which this decline took place (columns). Source: author's calculations.

Conclusion. This article considers only small aspect of Brexit and does not attempt to look at everything in one place. I see only one scenario for Scotland, which is to leave the UK. The main reasons are that it the equilibrium was fragile in 2014, and the difference between England's and Scotland's votes now is too significant, so it will inevitably swing the pendulum to "leave UK" decision. Be prepared for the market fall on that event. This vote by Scotland can be foreseen by the market, so volatility might stay low. The stronger market reacts on referendum announcement, the more it knows the outcome, and, therefore, the less will it knee-jerk move on actual referendum results. Be careful with long UVXY positions because of that, as it historically fails in 20% such cases. However, as seen in the last table, the results of one-off market dives can pay back well on long UVXY. I cannot tell you about risk/reward now, the fog will not go down before Scottish independence referendum date announcement.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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: The material presented in this article is provided for informational purposes only and is based upon information that is considered to be reliable.