VIX Sub 20: The Short Volatility Trade Is Back
Summary
- Historically, the short VIX trade has been appropriate with VIX under 20.
- ProShares Short VIX ETF benefits from falling VIX.
- S&P 500 at extreme valuation is the major risk to the short VIX trade.
The VIX CBOE Index is currently trading below 20, which is a very important level. As the chart below shows, the VIX trades above the level of 20 during the periods of US recessions, and the global financial crisis - and it tends to spike significantly during these volatile periods.
See below the cases of the above-20 VIX periods: 1) the US recession of 1991, 2) the emerging market financial crises in late 1990's, 3) the US recession of 2001, 4) the US recession of 2008, 5) the European financial crisis of 2012, and 6) the US recession of 2020.
As a trading strategy, the long volatility trade is appropriate when VIX is above 20, in expectation of the volatility spikes.
On the other hand, the chart above also shows that when VIX trades below 20, it tends to gradually decrease towards to support level of 10. These are usually the periods that start with the post-recession economic recovery, and last towards the end of the business cycle when recession probabilities significantly increase. During these periods, as a trading strategy, it is appropriate to short VIX in expectation of a continuous economic growth.
Currently, the VIX Index is below 20, which makes sense since we are just exiting the 2020 recession, and given the extraordinary fiscal and monetary policy support in the US and globally, the probability of a double dip recession is probably near 0%. Thus, in this situation it's reasonable to expect a gradual decline in VIX, which supports the short VIX trade.
The short VIX trade
The VIX futures curve is currently in a contango - the cash VIX level and the near month VIX futures are below the far month VIX futures, as the chart below shows, which supports the short VIX trade. For example, the cash VIX value is at 17.9, while the May futures value is at 21.5. Thus, if the cash VIX level remains at 18 in May, the May futures contract would decrease from 21.5 to 18 - which is a significant gain on the short May VIX futures, while the cash VIX level remained unchanged.
Source: CBOE
How to play the short VIX trade with ETFs?
ProShares Short VIX ETF (BATS:SVXY) rises as VIX falls. According to the fund's profile: "The investment seeks daily investment results, before fees and expenses, that correspond to one-half the inverse (-0.5x) of the performance of the S&P 500 VIX Short-Term Futures Index for a single day. The index seeks to offer exposure to market volatility through publicly traded futures markets and is designed to measure the implied volatility of the S&P 500 over 30 days in the future." The expense Ratio is 1.38% and the assets under management are $540.59M. The chat below shows that SVXY has been rising in response to falling VIX.
What are the Risks?
Shorting VIX when below 20 makes sense, based on historical analysis. However, we are currently right at the 20 borderline, and as such it's possible that VIX returns above 20 and spikes.
The major risk to the short volatility trade is the S&P 500 (SPY) valuation, which is extreme by historical standards. Specifically, the CAPE Shiller ratio is above 36, while the long term mean is 16.8. Thus, S&P 500 could significantly correct, which would cause a sharp spike in VIX.
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