Volatility Spike, Here We Come?

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Includes: VXX, XIV
by: Rahul Salgia

Summary

Non-commercials are the most net short ever.

Commercial hedgers are extremely net long.

XIV volume is very low and is less than the total shares outstanding.

The VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) is hovering near all-time highs as volatility continues to contract. Even though there is no fear in the market, the smart money is positioned to see a volatility spike.

According to the CFTC's commitment of traders, non-commercials (dumb money) are the most net short 172,395 VIX futures contracts as of 09.26. Compared against the last 13 years, this is the largest short position ever. These speculators are the most net long at the low end of the range for the VIX. Conversely, they were the most net long 37,925 contracts in September 2015. This was the time where the DOW crashed from 17,000 to 15,300 in a short period of time. At market extremes, these money managers/hedge funds are usually on the wrong end of the trade.

On the other hand, commercial hedgers (smart money) are net long 173,288 VIX futures contracts as of 09.26. This is an extremely bullish reading as this is the second largest long position ever. They were the most net short 37,512 contracts in September 2015. This was around the bottom of the stock market. These commercials have done a 180 over the past two years, and it may be wise to pay attention to how these smart investors are positioned.

During the last few years, the cash VIX index has been all over the map. VIX hit over 50 in 2015 as the markets slid sharply. Now the index is touching the 9 handle, and investors are extremely bullish. Investors profit from volatility contraction and the way they play it is by going long the XIV. When stock markets are rising, volatility tends to decrease. Traders have the option to short VIX futures or playing ETNs or ETFs like the XIV or the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). The XIV rose from 15 to 100 in a span of two years. This return is 566% over the last two years.

Tom McClellan, of the McClellan Market Report, indicates that the volume in the XIV is fading. His research indicates that when XIV's volume is less than the total outstanding shares of the ETN, then volatility is about to rally. From Sept. 5 through yesterday, the average volume of XIV is 7.6 million. The total shares outstanding are 10.8 million. If we don't include Sept. 5th's volume of 22 million, the average volume is 6.8 million. We can deduce that the smart money abandoned the trade temporarily as they expect volatility to rise, and they expect better entry points.

Even though the VIX is showing signs of investors complacency, the commercial hedgers are hinting that volatility is coming back.

Disclosure: I am/we are short XIV.

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: I play volatility from sides (in selling options) and have positions that are long volatility as well.