Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

2015 Correction

Or how I learned to stop worrying and love Volatility.

First off I don't know how far down we will go and no one else does for sure. Period. All we can do is look at the most likely scenarios, have a plan for when they happen, be flexible to adjust the plan in case conditions change and execute the plan. What I do know is history tells me every single correction (except Oct 1997 -11.2%) since 1993 has had at least 2 legs to lower lows. 1st leg ended on 8/25 and we have yet to have a 2nd leg to lower lows (although Friday is likely the start of that 2nd leg lower).

What else do corrections have? They have what I refer to as a draw within the draw. Big picture wise they go from a "Top" - "Bottom" - "Mid Top" -- "Mid Bottom" and then to new highs. I will use 2010 16% correction as my example. We fully bottomed at -16.1%, bounced to the Mid top of -7.2%, went lower to the Mid Bottom at -13.6% (notice not a lower low) and THEN moved to new highs. Top, Bottom, Mid Top, Mid Bottom - New Highs. This nature of a correction plays out over and over and over again if you look at historical corrections - I have charted the data back to 1993. The basic idea is the market hits pivot points where we are oversold/overbought compared to where we were - the market constantly over shoots and under shoots especially after a panic sell lower until finally after the Mid Bottom everyone decides to row in the same direction and the markets recover to new highs. Strange but true.

So my premise is we have yet to hit our true bottom and are still in the bottoming process. Fine. How do we trade it? Well I would start buying UPRO once we close at a lower low - current low is 187.27 SPY. I can't give you the timing of it other than to say buy after we get to lower lows. Then you hold until we make a significant move back up towards the mini-top then sell and start shorting, hold until we reach the new mini-bottom - sell and go long again but this time XIV and hold until new all time highs.

You are all probably going "wait a minute, I thought you were a Volatility guy not UPRO, why UPRO vs (NASDAQ:XIV) or (NYSEARCA:SVXY) until the Mini-Bottom?" The stats show during big draws of large backwardation (see summer 2011) UPRO outperforms XIV during the Bottom to Mid Top period (by 8.4%) AND Mid Top to Mid Bottom periods (4%). But XIV outperforms UPRO from the Mid Bottom to the new highs (18%). Why is that? Well in 2010 it was better to own XIV because Contango was strong throughout the draw - for goodness sake we had 6.4% roll yield and 4.2% contango on the day the SPY bottomed at -16% draw! So the contango wind was at your backs the whole time you were trying to pick a bottom. Fast forward to 2011 where average Contango during draw until bottom was -5.4% vs 1.5% for 2010 and you can imagine the tailwind vs headwind that contango plays for your XIV returns. By the time you hit the Mid Bottom though the market has decided we are not seeing lower lows, VVIX, VXST and VIX are lower than before and the futures curve reacts more normal then the panic it shows until then.

Contango was -5.4% 2011, 1.5% 2010 and currently we are at -9% average contango for this correction- Yikes! Now by the time we bottom that average may fall some but no matter what it will be negative by the bottom so the play is definitely or (NASDAQ:TQQQ) until we hit the Mid Bottom.

So on top of logic and history on your side you can also sleep better knowing if you buy UPRO at -14% and we go to -19% you will be down 15% as opposed to 2011 if you bought XIV (simulated XIV because it did not exist in 2011) the 2nd time the market got down to -17.4%....at the -19.4% bottom you were down 44% in XIV!! Think about that. Market down 2% (6% if UPRO and you are down 44% in XIV. Horrible play! 9.25 to 5.12. I am not saying that would/could happen this time but I am showing you it is much better to be safe than sorry. And to sweeten the pot more here are the returns if you nail the Mid Bottom in 2010 and 2011 buying XIV and holding until new SPY highs - 89% and 70%. The returns from UPRO are Bottom to Mid Top = 32% and 51%, Shorting 3x (SPXU/SPXS) Mid Top to Mid Bottom are 21% and 29%. So it pays to be safe now with UPRO (you get BETTER returns in UPRO vs XIV with big backwardation) and then after we recover a bunch, then fall back down but not to a lower low THAT is when you buy XIV and rake in the big bucks.

Good luck and happy trading!

   

Btm-Mid Top

Mtop -M Btm

MBtm-Highs

   

UPRO

UPRO

XIV

2010-07-02

-16.10%

32%

-21%

89%

2011-10-03

-19.42%

51%

-29%

70%

Disclosure: I am/we are long VXX, UVXY.

Additional disclosure: Small positions in VXX and UVXY. 98% Cash.