Betting On Volatility

by: Todd Feldman

Readers of our past articles have read that we use our own indicators for the US stock market to pinpoint cycles. Currently, our indicators have signaled the US stock market is in a 1987 type cycle. This does not mean we believe that the current US stock market will mimic the 1987 market exactly. However, the current market's ebb and flows should mimic that of 1987. The same type of analysis led to our article Sell in May and Go Away?, No. Buy in May and Sell Away. So far the two periods have been similar. Below is a figure of the S&P 500 price overlay between 1987 and 2012.

Figure 1: Overlay of the S&P 500 for the 1987 and 2012 period.

In recent articles we have written about how the next phase is a correction phase. We do not think the correction will be as large as in the 1987 correction. However, we believe there is a small probability that the correction we predict will play out in a similar fashion as in 1987. In 1987 the US stock market declined 22% in one day. On October 20th, 1987 the VIX hit a high of 172.79. Given there is a higher than normal probability of a 1987 type event we want to review the volatility trade.

Many traders short volatility to take advantage of contango. Traders will use some funds such as VXX, VIXY, TVIX, UVXY, or XIV to exploit the time decay and contango. If one shorts using a small part of their portfolio while keeping a lot cash on hand, one can make 10-15% per year. In addition, this trade seems to work the majority of the time. However, it is always possible to get an event such as back in 1987 that can wipe out your entire portfolio. If the VIX went to 172 a small allocation to the volatility ETFs can result in margin calls. One reason this trade may offer 15% a year, which is better than any mutual fund can probably offer, is the exposure to blow up risk. Owning the S&P 500 via SPY without margin you won't have to worry about blow up risk. The question to the volatility trader is, if the extra return is worth the higher probability of your entire portfolio blowing up?

Again, we argue that the US is in a similar cycle to 1987. This just means that the probability of something big occurring soon is now higher than normal.

Given our prediction we suggest to close your short volatility positions for the time being.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.