Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Time to Short the January VIX Futures

|Includes:Jefferies S&P 500 VIX Short-Term Futures ETF (VIXX), VXZ

 We have commented in the past on our preference to short volatility and express long positions on stocks by selling put options.  We executed this strategy with great success during the pullbacks of June and August.  However, there remains a potentially extremely profitable trade within the short volatility space.

Shown below is a chart of the January VIX futures contract.

 

As of today, the January VIX futures contract is trading at 30.15, down 15 cents on the day.  Take note that this contract is trading down -.5% on a day when it’s underlying index is trading up +4.1%.  Why is this the case?

The VIX is a mean-reverting index, meaning its’ protracted moves in either direction are likely to revert to their base at some point.  The fundamental reason for this is that the VIX measures the amount investors are willing to pay for insurance (specifically the implied volatility of the S&P 500 option contracts, with a heavy skew towards put options).  During times of great uncertainty or panic such as 9/11, the financial crisis, or the “flash crash” earlier this year, investors greatly increase the amount they are willing to pay to insure their stock portfolios.  However, as time passes and the psychological shock of the event dissipates, the VIX tends to drift downwards again as sellers of these insurance contracts are willing to accept less and less until the index reaches a level near to where it traded before the event.

As a result of this mean-reverting behavior, the relationship between options and futures on the VIX does not behave as it does for any other commodity, currency or stock.  VIX futures and options almost always trade at a heavy discount or premium to the underlying VIX index.

Currently, the VIX index is at 22.60.  At this level, the January VIX contract represents a 33.4% premium to the underlying VIX index.  This means that traders’ expectations for volatility in the future are tremendously higher than our current level.  While this can be taken as an ominous sign, it is worth noting that VIX futures for 3-6 months out have traded at heavy premiums to the VIX index ever since the rally starting in March 2009 began.  Simply put, there are many more buyers of volatility than there are sellers.

Our recommendation is to short the January VIX futures contract.  We believe that the current dislocation represents an enormous opportunity.  In order to turn a loss by selling a January VIX futures contract, the VIX index must by 33.4% higher upon expiration on January 18, 2011.  To illustrate the unlikelihood of that event, we have prepared the following chart of the VIX index over the past 10 years.

As can be seen from the chart, the 30 level on the VIX index has only been achieved and sustained rarely over the course of the past 10 years.  During the 2000-2002 bear market, the VIX index flirted with this level before skyrocketing above it after 9/11.  Between 2002-2003 the index was also above 30 for much of the remainder of the bear market, which witnessed aggressive selling of equities before bottoming in late 2002.  Between 2007-2009, the VIX witnessed an incredible spike due to the financial crisis.  The most recent spike above 30 occurred in May 2010, directly after the “flash crash” incident.

After each one of these shocks, the VIX witnessed a precipitous fall, mainly due to the mean-reversion nature of the index.  As we believe the summer correction was only a pullback in the context of a broader bull market, the January VIX futures are grossly overpriced.  In order for the VIX index to be above 30 upon expiration, a significant exogenous shock to the stock market would be necessary, and even if this shock is witnessed, it would need to be timed almost exactly at expiration due to the likelihood of the index falling as quickly as it rose.  Even if one believes that our current pullback is the beginning of a bear market, the magnitude of the decline in equities would need to be quite violent in order to sustain a level above 30 on the VIX.



Disclosure: Short VIX January Futures

Stocks: VIXX, VXZ