Implied Volatility Trackers keep declining
Implied Volatility was the strongest decliner during 2016. A long investment in implied volatility trackers would have been one of the worst investments you could have made in the beginning of this year.
Looking back on the performance of Implied Volatility trackers, we cannot say this decline was exceptional or unprecedented. Implied Volatility trackers like the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) (or leveraged variants like the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY)) have been losing money consistently during the past years.
Taking everything into consideration, 2016 could have been a bullish year for implied volatility. The markets were faced with multiple uncertain and volatile events:
- Oil prices faced volatility due to a slowdown in the Chinese economy.
- In the U.K. the Brexit referendum vote came as a complete surprise, putting pressure on stock prices worldwide.
- The European economy barely grew despite huge monetary stimulations by the ECB.
- Donald Trump's surprise win in the presidential elections.
These events did all have an impact on the stock market and even triggered short-term increases in the implied volatility index. These appreciations in implied volatility, however, were each time short-lived and the implied volatility pulled back to its long-term downtrend.
2017 will be no different for Implied Volatility trackers
While 2017 starts from a new perspective, we don't expect to see a reversal in the long-term downward trend of VXX.
- While the stock market did have its volatility run-ups and short-term corrections during 2016, the VXX just kept on declining. This can be explained by the contango-effect in the VIX futures. This has been covered broadly already here on SA (1,2,3). As we speak, the VIX futures are still marked by strong contango and we don't anticipate this will reverse its course toward backwardation in 2017.
- The U.S. economy is growing, the job market is improving, inflation is picking up again and stock markets are reaching new highs . Thus, we expect the economy to grow further in 2017 and in the years to come.
- During 2017 we expect a series of uncertain events which can trigger a short-term upward spike in volatility, but will only have a short-term impact on the long-term downtrend in the VXX. We list the 3 most important of them here:
- The Fed hinted at 3 rate hikes in 2017.
- Brexit: It is still unclear what kind of relationship will remain between the EU and the U.K. Will it be a hard Brexit (where the Britains give up full access to the single market and full access of the customs union along with the EU) of a soft Brexit as close as possible to the existing arrangements).
- Crude Oil prices: Will the oil market continue its recovery? Or will it turn global stock markets bearish again?
Implied Volatility trackers are too unpredictable and volatile for a simple short position
A simple short position in VXX would be dangerous however. Sudden unexpected news events can result in a short-term upward spike in its stock value. In 2016 we had several upward spikes in the VIX:
We can avoid these price spikes by buying put options on VXX after a sharp upward spike (for example for increases of 10% within 2 days). Here we could buy the out-of-the-money put option which expires in the front-month. After the run-up in stock price the premium of these put options will be very cheap.
In case the short-term upward spike should be the start of a continued uptrend in the VXX, the risk will be limited to the premium paid for the put options.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VXX PUT OPTIONS over 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.