Volatility Should Be Higher

by: Seethrough Macro


A number of indicators say equity volatility should be higher.

But long VIX is an uphill battle and a lottery ticket play.

Know when to fight the curve and when to profit from it.

A number of indicators suggest volatility should be higher. Below, we will examine these and the case for a higher VIX. Also examined is the compelling case for taking a short position on the VIX to benefit from the attractive contango yield that gets paid to short sellers of the VIX. In essence, the message is, be prepared for taking tactical long views on the VIX, but in the meantime, profit from this little-understood feature of the market.

1. Rates and FX volatility have been trending higher this year as the market prepares for Fed rate hikes. In the past, higher volatility in these areas has leaked across to, or coincided with, rises in equity volatility.


The link between equity implied volatility (the CBOE VIX) and the swap rate volatility index is clear, and a significant gap exists. The obvious question is when and how will this gap close? In the past, it actually looks like equity volatility pulls the other one down, but the present gap is notable.


2. Commodities volatility is likewise suggesting that equity volatility should be higher. The implied volatility index for oil is still trading well above its usual levels, and has broken from its tendency to follow equity volatility. The chart below shows a similar gap to that in the chart above, again a case can be made for equity volatility doing the work to close the gap; but the gap is notable.

Source: barchart.com

3. Sentiment on the VIX (from StockTwits) has become quite negative recently, and usually the signal that sentiment gives you is a contrarian one. So, you could say the market has become too pessimistic on the prospects for a VIX spike.


4. Futures positioning has also moved to considerable net-short position among speculators. As the chart shows, after dabbling in a long position earlier this year, speculators have moved to a considerable net-short position on the VIX. We will explore the real reason for this later, but on first impression, it looks like speculators are pessimistic on the VIX; expecting a lower VIX, while also being vulnerable to a short squeeze.


5. Mean reversion says the VIX should be higher; at the time of writing, it's about 25% below the long-term average of about 20, and history shows the VIX exhibits strong mean reversion tendencies. Also, relative to its 50-day moving average, the chart below would make a case for some mean reversion in that indicator (potentially driven by a sharp rise in the VIX).


6. The full moon signal; ok, so this one is half in jest, but there has just been a full moon, and that sometimes coincides with a turning point in the VIX.


So what? So, now that we've reviewed all the reasons that the VIX should be higher, here's the part where I tell you to buy VIX right? At this point, I should be walking you through the various VIX ETFs such as the most liquid long ETF; iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) - which also has an active options market, or perhaps tell you that the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ) is another alternative that uses mid-term futures, and thereby, has a lower cost of carry, or even that you could consider the leveraged long VIX ETFs; ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) or VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX).

But before doing that, it's worth looking at the chart below, which shows the shape of the VIX futures curve or term structure. This is the little-understood aspect that was referenced to at the start of this article and is the reason why if you bought the short VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) 3 years ago you would be up about 300% instead of down over 90% if you bought the long VIX ETF.


The reason is that for the VXX ETF to maintain exposure, it has to keep selling the shorter-dated futures (lower price) and keep buying the longer-dated futures (higher price). That is, sell low and buy high - not a recipe for success. In the case of April to May, this would incur roll costs (or a negative roll yield) of -9.5% (and that's just for one month). So, if you think about the futures positioning chart mentioned earlier, it makes sense that hedge funds should be selling VIX and pocketing this "easy money". But it's still not that simple; during the August 2011 S&P 500 correction, XIV fell over 70% and took over a year to make back the losses. So, in the long run, you could probably make money just by buying and holding XIV, but just be wary that the drawdown could be extreme.

For trading the VIX, all that glitters is not gold on both the long and the short side. While the VIX futures curve is in contango, it makes sense to own XIV - potentially with an out-of-the-money call on VXX as a crash risk hedge. When the stars align for a rise in the VIX, as they appear to be now, it may make more sense to own VXX on a tactical basis. But remember the curve, and also remember the best time to establish a position in XIV is just after a spike in the VIX. So watch this space.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.