Redefining the VIX

by: Stock Traders Daily

The VIX is not an accurate gauge of protection anymore. Instead, the VIX is a measure of speculation. My observations tell me that the VIX increases aggressively when speculators bet that the market is going to decline; the VIX no longer increases aggressively when investors seek to protect established long positions.

The reason is quite simple. The VIX is not directly correlated to the market, and therefore does not offer direct protection. In fact, the S&P 500 could decline, causing a loss in a broadly diversified portfolio, and the VIX could decline at the same time, negating its desired offset completely. Anyone using that instrument is not only faced with an uncorrelated measure of protection, but they are also faced with the inevitable fact that VIX contracts deteriorate and VIX ETFs are arbitraged by professionals every day, making them poor investments over time. Therefore, investors seeking protection are looking elsewhere.

My observations suggest that protection is being sought in high-volume short-based index ETFs. Instead of buying the VIX, VXX or VXZ -- instruments that are all intended to offset market declines but are still uncorrelated to the market -- investors are choosing to protect established long positions with directly correlated ETFs that do not have the same deterioration. TWM, SDS, DXD, and QID-OLD fit this bill. These short-based ETFs offer direct correlation without deterioration.

Reasonably, slight deterioration exists, but that deterioration is negligible and goes virtually unnoticed, so traditional measures of volatility and protection are giving way to different practices and definitions. Not only are investors choosing to offset their exposure during periods of market decline with managed ETFs instead of the VIX, but the definition of the VIX is changing as well.

The VIX now increases when bearish speculators enter the market, not when investors aim to protect positions anymore ... and that is just fine with me. Quite often that speculation is a leading indicator of future market decline, and a tool we can observe to get ahead of the curve. Recent days were an excellent example; VXX was up solidly. This told me that speculative bearish investors were taking positions ahead of what they thought would be additional decline. If this leading indicator proves to be true, then the days ahead will bring additional market decline and anyone who observed this VXX indicator could have gotten ahead of the curve.

From there, if history repeats itself, VXX will fall again like it has in the recent past. Once those speculators exit the trade, even if investors continue to hedge with other ETFs, VXX will be vulnerable to decline as well; this is a direct result of the new speculative nature of VIX versus directly-correlated short-based ETFs. Ultimately, I am using this past measure of risk and protection as a leading indicator to market decline and the short-based ETFs as the means to reach my goal. This has worked perfectly many times this year already, and like some of our granddads used to say (or not), "If it ain't broke, don't ‘VIX’ it."

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