I am introducing a new article series with an overwhelming focus on VIX and VIX-based derivatives, as well as the true drivers of short-term performance of the two. The "VIX Peaks" series will closely track the weekly fluctuations in the VIX futures and provide actionable insight near the cyclical upturns (for one to cover VIX-related shorts before a major trend reversal) and downtrend resumption points (at which one can reestablish the shorts and/or close the short-term long positions).
Despite the popular view that a Trump presidency would send waves of shock to the global financial markets (which it actually did in the very short term), a fast-paced rally to new all-time highs followed in a matter of days. Despite enjoying strong momentum since the announcement of the U.S. election results, the S&P 500 (NYSEARCA:SPY), Dow Jones Industrial (NYSEARCA:DIA) and Russell 2000 (NYSEARCA:IWM) have all been relatively weak after briefly setting new records this Wednesday. As the boost coming from decreased political uncertainty amount has been starting to diminish, the time has come for the market cyclicity to return. Quite notably, the post-elections effect has been unevenly distributed among different sectors.
Plunging to 66 from the recent high of 79.91, the RSI of the Russell 2000 clearly indicates that the index has gotten too far, too fast. While the S&P 500 has demonstrated an RSI downturn to 59.85 from the previous week's high of 70.69, the Dow Jones Industrial is holding up stronger, having its RSI remain nearly unchanged at 74.77 compared with the Friday's value of 76.3. As opposed to the Dow Jones, Slow Stochastic dynamics of the S&P 500 and Russell 2000 indicate that the two indices have suffered a strong momentum downturn since last Friday.
Providing a major post-elections relief effect, the rally produced a collapse in 30-day expected volatility of the S&P 500 as represented by the VIX index, triggering a parallel decline in the value of short-term VIX (VXST), which focuses on nine-day expected implied volatility of the S&P 500. Suffering a fall below the often critical value of 10, the index has been on a strong cyclical rebound lately, suggesting increased near-term implied volatility values demonstrated by the weekly S&P 500 options.
Falling below the crucial level of 10, the VXST moved to the lows it doesn't usually spend too much time at.
Source: Made by the author using the data from Investing.com
VXST also serves as an underlying index for the widely-recognized volatility ETFs such as the iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX), ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) and VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX). However, although VXST often precedes the major movements of the VIX and can be used as a short-term market barometer, one cannot base investment decisions on oversold values of the index, as suggested by the table below. Even though the indicator might be rather useful at times, average historical returns do not seem too compelling considering the level or risk involved.
Source: Made by the author using the data from Investing.com
Speaking of risk
Before I commence with the analysis of the investment tools mentioned above, it is crucial to mention that these vehicles are often subject to enormous underperformance over the periods exceeding periods as little as one trading day. Aimed to replicate the VXST index fluctuations, holdings of VXX, UVXY and TVIX are required to constitute the front-month and second-month VIX futures contracts. Since the VIX futures curve is generally upward sloping, daily rebalancing has an adverse impact on these investment tools' value even over the short term due to the contango effect. In other words, with each passing day, the VIX ETFs/ETNs are forced to hold a smaller fraction of the front-month VIX contract and a larger fraction of the next-month contract - a rather costly conversion.
Currently, the holdings of discussed VIX ETFs are distributed between the VIX December 2016 (44%) and VIX January 2017 (56%) futures contracts. Any short-term appreciation - in the form of cyclical downtrend reversals - of these two contracts might result in sharp increases in the value of the traded VIX products. Even though the upward-sloping VIX futures curve implies constant profits if one shorts the VIX ETFs over extended periods of time, ill-timed entries might result in significant paper losses if a cyclical reversal occurs. On the other hand, one can maximize profits by shorting at intermediate tops. It is true that significant short-term returns can be achieved if one goes long the VIX products before a cyclical upturn begins. This, however, requires truly precise timing and, as many investors familiar with the subject know, is easier said than done as time acts against investors' returns in that case.
Using the data from options with 23-37 days to expiration, the VIX index is composed of multiple moving parts, including the following:
- S&P 500 index forward values;
- numerous strike prices of out-of-money call and put options;
- time metrics (expressed in minutes); and
- bond-equivalent yields of U.S. Treasury Bills (NYSEARCA:BIL).
The diagram below summarizes the process of VIX value calculation:
Near-term and far-term VIX values
Two main components of the final formula (see the bottom of the diagram above) - the near-term (VIN) and the far-term (VIF) values of the VIX - have just recently bottomed. As indicated by VIN's technicals, S&P 500 option activity is slightly more bullish on VIX readings in the earlier part of the 30-day period.
In the meantime, despite the significant depreciation since the U.S. election results announcement, Dec 16 and Jan 17 VIX futures contracts continued to underperform throughout the week of November 28-December 2. Even though the low VIX values could have fooled contrarian investors, historical MACD dynamics suggest low possibility of a major spike before the divergence turns positive. With the latter becoming increasingly less negative, improving RSI and Slow Stochastic dynamics suggest that the VIX might have already reached another intermediate bottom and is ready to experience a cyclical trend reversal.
With VIX at cyclical lows, a major positive event would be required to cut the current reversal short. Down from 12.62% a week ago, decreased contango - at 11.36% as of this writing - is going to positively affect the VIX ETFs' performance in the very short term, which are already performing quite well following the OPEC deal news. Adding to the uncertainty is the 98.6% futures-implied probability of a 0.25% rate hike at the Fed's December meeting and the upcoming Italian referendum. Although one might argue that the Fed can proceed with an even stronger move later this month, what is more certain is that the Fed will most probably use its chance to hike as the market is finally prepared for the second rate increase. In the meantime, having just recently increased their net-short positioning in VIX futures, large traders might be caught in a brief short squeeze rally in the coming weeks.
Why is all of that important to the markets?
Indicative of increased hedging activity in the near-term S&P 500 options, recent VIX futures dynamics provide a warning. While the short-term-focused investors might want to readjust their positioning and pay more attention to intra-portfolio correlation, long-term investors might have more stock-buying opportunities in the coming weeks. Even though the negative MACD divergence suggests that the VIX spike will most probably be short-lived, there is a possibility of it resuming once the divergence turns positive (as it was in June and October).
To sum up, it is becoming increasingly risky to remain short the volatility ETFs as we are heading into the next week. Even though the current technical signals only support a short-lived VIX uptick, any negative market and/or economic developments might lead to a sharp index reversal, which is currently in preparation. Having recently sold my VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) shares, which I've traded for the purpose of shorting the VIX futures, I continue monitoring the VIX for a cyclical re-entry.
On the other hand, the risk/reward of going long the VIX ETFs has substantially improved. Investors willing to obtain exposure to the related ETFs should be aware of the risks involved and only trade the long-VIX products for limited periods of time. While the technical signals I am describing throughout the article can improve investors' entry timing, it remains quite a challenge to time the sale successfully. I will proceed with a follow-up article once the next cyclical reversal emerges.
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: This is not an investment advice. I am not an investment advisor.