Shorting the VIX has been more of an art than a science the last few years - perpetually rolling off volatility post-financial crisis has created a one-sided trade that was bound to unwind at some point. conflicts of say the geopolitical nature were quickly resolved in a matter of hours as traders assigned probabilities to outcomes and determined no real threat to the market. Today, you saw short sale rules go into effect on some ETFs that broke their circuits and those who were leveraged on those trades almost absolutely got margin calls unless they sold early in the morning. I advise investors to not trade these products in the short-term.
The VIX Puts On A Show
The VIX is up 158% in three days and while I did not think I'd be saying that this early in the year, welcome to reality. Within this, Monday's spike was roughly 120% (~+90% at market close), with many levered ETFs underperforming the index, which could lead to outsized movements in these products over the coming days.
I'm looking at inverse volatility ETFs like VelocityShares Inverse VIX (XIV) that were trading down absurd amounts (XIV is down 80%) post-market. These products shouldn't be traded without expert knowledge of how the VIX works and the many fine details of how these products work, as nearly all the inverse ETFs experienced massive depreciation of NAV today. Long VIX ETFs, on the other hand, like iPath Short-Term Long VIX ETF (VXX), are up over 75% post-market.
Additionally, those looking to access VIX longs/shorts via options also need to exercise temperament. A unique factor in the pricing of options is implied volatility and without boring my audience as to how that fluctuates and how to trade off of it, know that it is extremely elevated right now. All else equal, higher implied volatility means options prices are more expensive.
The best thing retail investors can do at this moment in time is not try and attempt to trade volatility, let alone take a position with a large percentage of total portfolio capital. With the way the VIX has moved this year, i.e. not in the traditional correlation it has held (inverse) to the S&P 500, outsized moves in the VIX can cause retail investors to experience losses that they could have avoided if they had stuck with their normal stock picks.
What Happens Next?
What I think the VIX does from here is remain elevated. The reason that I am not picking a direction on the index is because the next move is highly uncertain for equity indices and that doesn't necessarily equate to a higher VIX, like it used to. When an inter-market relationship that investors have known for years breaks down, it's time for retail investors to revert to a significantly safer strategy until the relationship normalizes.
If you're a retail investor sitting at home wondering what's changed today, fundamentally, ask yourself a few key questions, what major thematic difference is present today that wasn't present yesterday or even a month ago? Additionally, what's the potential downside fore equities from the current level?
I truly believe nothing fundamental has changed. Investors are still concerned about inflation, the pacing of Powell's Fed, and global quantitative easing reductions, among other items. There are still fantastic reasons to invest, however, namely global earnings growth. Just to focus on the U.S., the S&P 500 is on track to have earnings growth above 12% this year, indicated by Q4 2017's results so far (as they help to reflect the impact of tax reform and what to expect for CY 2018).This is an equity market worth buying into.
As I stated in my first article, excessive volatility is fantastic for the merger arbitrage strategy and investors would benefit from buying announced targets with minimal antitrust risk and a short timeline to close. To provide an example, I really like Aetna/CVS. The spread this time last week was 6.1%, which is still a decent return. However, this has now widened to 14% - capitalizing on that is an excellent trade as the fundamentals of the two companies haven't changed overnight and there's no more antitrust risk than there was yesterday or even the week before. Use the large move in volatility to your advantage without exposing yourself to excess risk.
The S&P 500 is only down ~1% YTD and while this sell-off has been very rapid, this is by no means the time to panic, even if there is further downside.
Don't try to call the top on volatility and don't try to call the bottom in equities. There have been many funds and exceptional investors that have tried to do this before and have failed miserably. The focus the next couple of days/weeks should be geared towards capital preservation. let the volatility trade work itself out and stay removed from it. Look for single stock names that have either retraced recent earnings season gains or are trading at a significant discount to where they were just a few weeks ago. Quality businesses that still benefit from the same structural tailwinds that the market has been riding for many months now is where investors want and need to be.
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.