VIX Is Not Dead Yet

by: Simple Digressions


VIX futures are sending an interesting message now.

The ratio of long positions in VIX futures held by Commercials to their short positions is standing at its highest reading in history.

Speculators hold one of the largest short positions in VIX futures.

In my opinion, the VIX futures market is overcrowded now, and initiating new long positions in US stocks does not seem to be a prudent idea.

A few months ago, I published an article on the US stock market. I was quite confident that US stock prices were going to go down soon. And... I was wrong and punished. The market went up and I lost money. In this article, I am not trying to predict the market. What I want to do is to show, using a few charts, the current overbought and overcrowded state of the US stock market. However, it does not mean the market is going to crash. First of all, we are still in a bull market in stocks. In such a case, the following old rule, taken from the legendary speculator Jesse Livermore, is valid:

"Mr. Partridge, would always politely tell the younger speculators who asked him trading questions that it was a bull market. The young speculators were always eager to trade, but Partridge was old and battle-scarred enough to know that no mere mortal could even hope to catch every individual fluctuation so the wisest strategy was just to ride the major trends. His simple reply, which would annoy the youngsters since they could not yet perceive the deep wisdom in it, was to subtly advise them to just ride the primary trend and not worry about rapid-fire trading."

On the other hand, in my opinion, a few indicators suggest that the stock market has entered an uncharted territory and opening new positions is risky now. Let me discus these indicators.


At the start, let me go back to the definition of VIX. According to Investopedia:

"VIX is the ticker symbol for the Chicago Board Options Exchange (NASDAQ:CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the "investor fear gauge."

Some people say VIX is dead now. Their reasoning is as follows: despite very low readings of VIX that are prevailing, which is an indication of overbought conditions, US stock prices go up again and again.

In my opinion, these claims (that VIX is dead) are unfounded. What is more, an unorthodox approach to VIX still delivers quite useful information.

Currently, it looks like the VIX futures market is overcrowded. The chart below shows the total open interest, starting from middle 2009:

(Source: Simple Digressions and the COT data)

The green circle indicates the highest readings in history. Since the summer of 2016, around 400-550 thousand contracts have been played by American investors. Two weeks ago, the open interest nearly peaked at 537.7 thousand contracts. It means a lot of investors were betting on the US stock market. And when any market measure reaches its extremes, this occurrence should be closely screened. Simply put, extreme readings may deliver essential and useful information.

Now the question is, who bets on what. Using the COT reports' terminology, the VIX futures market may be described as follows:

Speculators make their bets, and Commercials make these bets available.

In other words, generally it is the speculator who initiates the trade (he/she opens a position in VIX futures), and the commercial entity stands on the other side of the trade. When US stock prices go up, speculators (mostly trend followers) are betting on higher prices and lower VIX readings (VIX goes opposite to stock prices). It means speculators hold short positions in VIX futures. On the other hand, Commercials, standing on the other side of the trade, hold long positions in these contracts. This pattern lasts as long as a bull market in stocks is alive. However, sometimes the positions held by speculators and Commercials may reach their extremes. If such is the case, Mr. Market wants to tell us something important.

Below I have plotted a chart showing the ratio calculated as:

Total long position held by Commercials divided by total short position held by Commercials

(Source: Simple Digressions and the COT data)

As the chart shows, most recently, this ratio hit its extreme reading of 4.35. It means the size of the long position held by Commercials was 4.35 times their short position. Putting it differently, in general, Commercials were holding only long positions in VIX futures. On the other side of the trade were, of course, speculators holding a record large net short position (the circle marked in green):

(Source: Simple Digressions and the COT data)

Now let me summarize all these observations and formulate the main thesis:

  • The size of the VIX futures market is at its extremes now (the highest open interest in history).
  • Speculators are not only betting the most in history but their net short position is standing at highest readings as well.
  • The validity of the highest net short position held by speculators is additionally reinforced by the highest ratio of long/short positions held by Commercials.

The main thesis standing behind these observations is as follows:

The US stock market is at a historic and unique moment currently. Assuming that VIX futures offer an interesting opportunity to bet on the direction of US stock prices, this play is overcrowded. Using different wording, every single speculator seems to be betting on higher stock prices, and the size of this bet stands at its highest level in history. In my opinion, such an overcrowded market does not offer an interesting buying opportunity. While the overall trend of the US stock market is clear (upward), it is not prudent to add new long positions now.

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.

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