As most of you who follow my daily volatility commentary on my website or have read my previous Seeking Alpha articles would know, I like to point out opportunities for implementing long volatility strategies when they become available. Many people make comments asking why they should bother looking at long volatility strategies when short volatility has been a proven winner over time. My short answer is that while short strategies are usually winners when the volatility term structure is in contango, there are always exceptions. Whether an investor cares to consider long alternatives is always a matter of preference and risk tolerance, but they do exist and many nimble traders are able to take advantage of them. With that said, I believe we have recently entered a market environment where a long volatility strategy could prove profitable in the near term.
For the purposes of this article I will use the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) as a proxy for long volatility. There are other long exchange traded products (ETPs) such as UVXY and TVIX (both leveraged products) as well as options and futures that can be used to implement a long strategy too. Below I lay out the factors that I believe make a long VXX strategy attractive over the next couple of weeks.
Near Term Catalysts for Long Volatility
Extreme Market Valuation Levels: Market valuations have been increasing for some time now, and they have reached levels previously seen just before market pullbacks. Whether you look at earnings multiples, technical measures or S&P 500 relative strength in the 70-80s range, the current market rally looks like it may have gotten ahead of itself. Optimism seems to be the most touted measure that pundits point to as justification for further positive equity performance. But, as any market veteran knows, investor optimism can reverse very quickly as markets start to decline. Of course, all of these factors could persist for some time. But, they can't move much higher, and market measures always eventually revert toward their mean.
Low Institutional Hedging: Institutional investors are starting to believe that portfolio hedging is unnecessary because equities have only been increasing in value recently. While anyone who buys any kind of insurance like this knows, you don't buy insurance because you want to use it. You buy it to protect yourself from the many uncertainties outside of your control. I'm not going to cancel my health insurance tomorrow because I have not had a life threatening illness yet. I hold it just in case of unforeseen potential future outcomes. I really hope to never use it, but I know that if I don't, I am still covered just in case.
Portfolio managers realize this, but are under pressure to exceed benchmark returns. This has become an even larger issue as passive index investing has become increasingly popular lately. Many fund managers have come to view hedging with volatility products as an unnecessary cost and drag on performance. However, as any long term investor knows, markets do not always increase in value, and portfolio hedging is a means to buffer portfolio volatility over time. During periods of market pullbacks, active managers will turn to hedging strategies. And, given low current institutional exposure, this will lead to more pronounced spikes in VXX, the VIX index and volatility ETPs.
Impending Fed Interest Rate Hikes: Speaking at an event on March 3, Fed Chair Janet Yellen seemed to make quite clear that the FOMC will likely hike rates at their meeting in mid-March. She went further to state that the Fed was near its employment and inflation targets, and the Fed would likely be moving away from an accommodative stance to a more neutral position going forward. This is not something new as the Fed made clear in December 2016 that they expect three interest rate hikes during 2017. But, this move was not expected by markets to happen in March, and many will now be forecasting a more accelerated rate hike schedule going forward. Higher borrowing rates are usually not a positive for corporate interest expenses or the value of future expected cash flow receipts. Higher rates lead to greater uncertainty in earnings, and greater uncertainty fuels volatility.
Extreme Market Sentiment: Bullish market sentiment has reached very high levels. As mentioned above, optimism can last for unexpectedly long periods of time. But, many times before, extreme market sentiment has proven itself to be a contrary indicator. Bullish sentiment has preceded many market downturns. This has been especially true when retail investor sentiment has been high, and retail sentiment has been on the rise recently.
Given the catalysts mentioned above, a long VXX position could be a profitable strategy over the next two weeks. Whether used as protection for an equity portfolio in case of a market downturn or as a speculative trading position, the current equity market environment possesses the elements that make mean reversion more likely. While elevated equity levels could persist for some time, a long VXX position can allow investors the opportunity to take advantage of a near term increasing volatility environment.
As always, I strongly urge anyone considering this type of investment to fully investigate the performance characteristics of any security they are planning to use before implementing any trading strategy. This article is just my opinion, and I encourage all readers to decide for themselves whether they find the contents relevant to their own situation. If you find my articles interesting, informative and useful, please follow me by clicking on the follow button at the top of the article. To view my past articles, you can look here. Thank you for reading.
Disclosure: I am/we are long VOLATILITY.
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.