The Spectacular VIX Tailwind Trade

This is a reprint of the August 24 Special Profit Radar Report:

The CBOE Volatility Index (VIX) is a popular index, but in itself is not investable. You can’t just go out and buy the VIX. The same is true for the S&P 500 or any other index.

But investment vehicles like the SPDR S&P 500 ETF, which aims to replicate the performance of the S&P 500 index, make it possible to invest in indexes.

Duplicating the performance of the S&P 500, however, is much easier than creating a vehicle that mimics the VIX. Fund managers simply purchase the stocks that make up the S&P 500 to create an S&P 500-like product.

It doesn’t work like this for the VIX. Here’s why:

There is no ‘VIX stock.’ The only way to invest in the VIX is via futures or options, which are complex financial instruments. ETFs, ETNs or other ETP’s use futures or options to attain ‘VIX-like’ performance. VIX futures and options generally suffer from some sort of time decay.

Explained: Contango

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create ETPs like the iPath S&P 500 VIX Short-Term Futures ETN (VXX) are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

Figure 1 compares the current spot price with various futures prices. The difference between the spot price (12.20) and the September futures (13.45) is 9.84%. In other words, it will take a 9.84% move in the VIX to neutralize the time decay between the spot and September futures price.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

Contango generally exists when the VIX is flat or trending lower. Even gradual increases when the VIX is below 20 tend to occur in an environment of contango.

Backwardation (figure 2) is the opposite of contango. Backwardation generally appears only during times of panic and significant VIX spikes above 20.

To sum up, contango erodes investors’ returns during periods of a flat or falling VIX.

How to Profit from Contango

We don’t expect a major stock market top yet, therefore the period of low volatility is likely to continue (or resume after the seasonal October VIX high).

Is it possible to use contango in our favor?

Figure 3 plots the VIX against the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), and reveals a very simple truth: XIV has risen much more than the VIX has fallen.

Figure 4 shows the cumulative gain/loss from January 3, 2011 to August 15, 2014. The VIX lost 25%. XIV gained 242%. XIV returned 217% more than the inverse VIX.

XIV’s objective (and the objective of every other inverse or leveraged ETP) is to replicate the daily (not long-term) inverse performance of the VIX, but regardless, this kind of excess return is worth exploring.

Here is a more detailed breakdown of XIV’s excess return.

XIV is an inverse VIX ETN. For an apples to apples comparison, we are comparing XIV with a simple inverse VIX.

Of the 911 trading days from January 3, 2011 to August 15, 2014, the inverse VIX had 484 up days and 427 down days. The inverse VIX had 1.13x more up than down days.

The average gain of 484 up days was 4.55%. The average loss of 427 down days was 5.85%. The average loss was 1.28x greater than the average gain.

Of the 911 trading days from January 3, 2011 to August 15, 2014, XIV had 522 up days and 389 down days. XIV had 1.34x more up than down days.

The average gain of 522 up days was 2.63%. The average loss of 389 down days was 3.18%. The average loss was 1.21x greater than the average gain (see figures 5 and 6).

Summary

Since 2011, XIV outperformed the inverse VIX by 217% (0.24% per day). Although there are other factors at work, the excess return of 0.24% per day is largely attributed to the effect of contango.

Contango does not guarantee a profitable trade or protect against losses. From July 7 – November 21, 2011 XIV lost 75%. There are also times where the VIX moves lower and XIV loses value (i.e. August 18 – 21, 2014).

Over time however, contango significantly enhances the odds of a successful XIV trade, especially when XIV is purchased during times of VIX spikes.

A list of VIX Exchange Traded Products that benefit from contango, a updated VIX seasonality chart, and actual buy/sell signals are available via the Profit Radar Report.

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

3 Tricks for Trading the VIX

More than any other asset class, the Volatility Index (VIX) is subject to distinct patterns or biases that either help or hurt investors.

Being aware of the 3 VIX tricks discussed below will significantly increase the odds of a winning trade.

1) VIX Seasonality

I invite you to inspect the VIX seasonality chart below. Based on 25 years of trading history, there are two important seasonal turning points: July 2 and October 9.

The VIX has a strong tendency to move higher starting in early July (green arrow), and to move lower after early October (red arrow).

For example, the June 23, 2015 Profit Radar Report stated that: “The VIX closed below the lower Bollinger Band for the first time since June 6, 2014. A close back above the lower Bollinger Band will be a buy signal. VIX seasonality is soon turning higher for the best VIX seasonal signal of the year.”

Shortly thereafter the VIX rallied from 12 to 20 and eventually to 50.

Due to the massive summer spike, this year’s October sell signal was shifted.

Nevertheless, the November spike (last chart, red arrow) offered a good setup to short the VIX, as the November 16 Profit Radar Report brought out: “The VIX closed below the upper Bollinger Band, which is a sell signal.”

The October sell signal is particularly intriguing because it gets magnified by a major bias of inverse VIX ETPs (Exchange Traded Products, such as ETFs and ETNs). This bias can be worth 0.25% per day for weeks.

2) Inverse VIX Bias

ETPs like the iPath S&P 500 VIX ETN (VXX) or the VelocityShares Daily Inverse VIX ETN (XIV) use futures (or options) to replicate VIX-related performance.

The performance of futures-based ETPs is typically cannibalized by a condition called contango. However, a bet on lower VIX prices allows investors to turn this generally harmful condition into a superbly beneficial tail wind.

Below is an admittedly dry explanation of contango, but I think you will find it well worth your time (no pain, no gain).

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create VIX ETPs are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

Contango generally exists when the VIX is trading below 20. The opposite of contango – backwardation, when future VIX prices are lower than at present – generally appears when the VIX trades above 20.

I wrote a detailed report on how to actually make contango work for investors back on August 24, 2014 (entire report available to subscribers of the Profit Radar Report).

Below are some of the findings and charts shared in this report:

The two biggest beneficiaries of the ‘reverse contango’ benefit are the VelocityShares Daily Short-term VIX ETN (NYSEArca: XIV) and ProShares Short VIX Futures ETF (NYSEArca: SVXY).

The chart below compares the VIX with its inverse counter part, XIV. Shown is the cumulative percentage return from January 3, 2011 to August 15, 2014.

It quickly becomes obvious that XIV has risen much more than the VIX has fallen.

XIV is an inverse VIX ETN. For an apples to apples analysis of the excess return, here is a comparison between XIV and an inverse VIX (the VIX inversed).

  • Of the 911 trading days from January 3, 2011 to August 15, 2014, the inverse VIX had 484 up days and 427 down days. The inverse VIX had 1.13x more up than down days.
  • The average gain of 484 up days was 4.55%. The average loss of 427 down days was 5.85%. The average loss was 1.28x greater than the average gain.
  • Of the 911 trading days from January 3, 2011 to August 15, 2014, XIV had 522 up days and 389 down days. XIV had 1.34x more up than down days.
  • The average gain of 522 up days was 2.63%. The average loss of 389 down days was 3.18%. The average loss was 1.21x greater than the average gain (see figures 5 and 6).
  • From January 3, 2011 to August 15, 2014, XIV outperformed the inverse VIX by 217% (0.24% per day).

Obviously the reverse contango benefit doesn’t guarantee a profitable trade, but on average XIV provides a ‘daily edge’ of 0.25%. At times, the edge is much more pronounced, such as on November 30, 2015, when the VIX rose 6.68%, but XIV gained 0.74% (when it should have lost some 6.68%).

VIX Technical Analysis

As you may have noticed from the two above Profit Radar Report quotes, the Bollinger Bands can be very helpful when it comes to spotting buy/sell signals, especially when they occur near the two major seasonal turning points (see chart below).

Simple support/resistance levels and trend channels can also be of help. The green/red arrows below highlight the buy/sell signal given by the Profit Radar Report.

Summary

Seasonality and technical analysis triggered a VIX sell signal on November 16.

The sell signal remains active and the ‘contango tailwind’ should by overall positive for XIV until late December.

However, for the first time since the start of the 2009 bull market, we are seeing signs of distribution (liquidity is drying up). This could become an issue when the next (bullish) VIX turning point arrives.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Stock Market Money Flow Check

Every once and a while it’s a good idea to check equity money flows, kind of like a GPS for what the money is doing.

Here’s a series of three charts to help us do just that.

1) Asset Allocation

In March, exposure to stocks (according to the American Association for Individual Investors asset allocation survey) soared to the highest level since the 2007 financial crisis.

This sounds scary, but the long-term asset allocation chart helps put things into perspective. Leading up to the 2000 market top, investors had up to 77% of their portfolio in stocks, and up to 69% in 2007.

2) Commercial Traders

The chart below shows the net S&P 500 e-mini futures contracts held by commercial traders. On balance, commercial traders are more or less neutral.

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3) VIX, Put/Call Ratio, SKEW

Chart #3 plots the S&P 500 against three different sentiment indicators:

  • CBOE SKEW: The SKEW was designed to measure the risk of a ‘Black Swan’ event. Higher SKEW = higher risk.
  • CBOE Equity Put/Call Ratio: This ratio shows to what extent option traders favor call options over put option. Lower readings = more optimism = more risk.
  • CBOE Volatility Index (VIX): The mix shows the market’s expectation of 30-day volatility. Lower VIX = Elevated risk. The VIX has lost much of its contrarian indicator mojo starting in 2012.

The CBOE SKEW (5-day SMA to smooth out daily swings) is near the lower end of a two-year range.

The CBOE equity put/call ratio dropped to 0.46 yesterday, a 1-year low. The 5-day SMA is not as low, but still at the lower end of an eight-month range.

The VIX is back to what used to be considered the ‘danger zone.’

Summary:

Money is flowing into equities, but there are no screaming investor sentiment extremes. Anyone claiming that stocks will crash because any one single sentiment gauge is at financial crisis levels is taking things out of context.

Detailed investor sentiment analysis is available to Profit Radar Report subscribers.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

 

VIX Says: S&P 500 Traders Getting Too Callused

Please suffer with me through a somewhat boring but necessary 3-paragraph discussion on VIX vs volatility:

There’s a difference between volatility and VIX volatility. Volatility in general refers to rapid changes. For instance, someone may say: “Volatility will pick up around the Fed announcement.”

This may well be true, but increased volatility does not necessarily translate into higher VIX readings.

The VIX measures perceived risk. Perceived risk almost exclusively increases with falling prices. That’s why implied volatility (VIX) is susceptible to directional movement, not movement in general.

A VIX at 16, as the case right now, implies a 16% move (up or down) over the next 12 months (or 4.62% of the next 30 days).

Now we skip from VIX volatility to actual volatility. There are different ways to measure actual volatility; one way is Average True Range (ATR). ATR measures the trading range, in this case daily over 30 days.

The chart below plots the S&P 500 against ATR and the VIX. Something unique happened in January/February 2015.

S&P 500 trading got more violent and the ATR soared to 26 points. The VIX on the other hand stayed well below prior highs. In fact, it maintained a string of lower highs.

Is there anything we can learn from this, or is it just a piece of worthless academic research.

I actually think there are two noteworthy takeaways:

  1. Investors didn’t overact to the January/February correction. Throughout much of 2013 and 2014 even the smallest corrections (we are talking 5% or less) saw VIX spikes around 50%.

    This kind of panic triggers immediate bearish extremes, and limits the down side. The opposite is true for complacent responses. VIX complacency during selloffs allows for more down side and choppier trading activity.

  2. As the green trend line shows, the VIX has been sneaking higher, despite an relentless S&P 500 (NYSEArca: SPY) rally. Why is this significant?

    Bear markets do not start with the VIX at record lows! Again, bear markets do not start with the VIX at record lows!

    Back in July 2014, when the VIX was near 10, I wrote a special report (available to Profit Radar Report subscribers) titled “The VIX is too LOW for a Major Market Top.”

    The report pointed out a simple fact that was overlooked by all the experts calling for a market crash (just because the VIX was near 10):

    When the S&P 500 peaked in 2000 and 2007, the VIX wasn’t at its low. At the March 2000 high, the VIX was at 22. When the S&P topped in 2007, the VIX was at 16.

Based on the 2000 and 2007 pattern, the slow VIX ascent may actually be a longer-term warning sign.

My reliable ‘ultimate top indicator’ has not triggered a ‘major market top alert’ yet, but the sneaky VIX up trend seems to indicate we are inching closer, certainly closer than we were in the summer of 2014.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

The ‘Original’ VIX Hits ALL-TIME LOW

The VIX, as we know it, is trading near lows not seen since February 2007. The original VIX, which has a price history going all the way back to 1986, just fell to an all-time low. By this measure volatility has never been lower, the implication is not what many would expect.

The VIX as we know it is trading near an 88-month low, but the ‘original’ VIX – VXO – just dropped to an all-time low.

What is VXO, aka the ‘original’ VIX?

According to the Chicago Board Options Exchange (CBOE), the VXO is now known as the CBOE S&P 100 Volatility Index. In 2003, the original VIX was renamed VXO and replaced by the VIX as we know it today. The VIX is based on prices of S&P 500.

VXO (prior to 2003 called VIX) is based on S&P 100 options. The S&P 100 captures 57% of the market cap of the S&P 500 (NYSEArca: SPY) and includes the largest and most established companies of the S&P 500.

The VXO has a price history dating back to 1987, which includes the 1987 stock market crash, ‘affectionately’ dubbed ‘Black Monday.’

The chart below plots the S&P 500 against the VXO (going all the way back to 1986).

The only way to stuff 38 years of price history legibly into one chart is with monthly bars. However, it’s a bit difficult to discern certain correlations on monthly bars.

What we can see is that the VXO fell to an all-time low last week. Lower than it was prior to the 1987, 2000, and 2007 market crashes.

Many mistakenly conclude that a low VIX (or low VXO) foreshadows a major market top. This is false. A special report issued by the Profit Radar Report examines the evidence and came up with a surprising conclusion: The VIX is actually too low for a major market top (click here to gain access to this VIX report).

But that doesn’t mean that the VIX can’t go any higher. In fact, this chart – which correctly predicted that the VIX will continue to slide lower until now – shows that the VIX should soon start to move higher.

Why the VIX Should Start to Rally Soon

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

VIX at 5 ½ Year Low – What Does it Mean for Stocks?

The VIX staged a historic performance over the last 16 trading days. It took 8 trading days to soar 47% and another 8 trading days to drop 43% to a 72-month low. What’s next for the VIX and what does it mean for the S&P 500?

From December 28 – January 9 the Volatility Index (VIX) dropped 43%. Such deterioration of implied volatility is unprecedented in the 20+ year history of the “Fear Index.”

On Wednesday, the VIX fell as low as 13.22, the lowest level since June 20, 2007. Extremes like this often plant the seeds for massive trade opportunities, they are music to our ears.

Is there any significance to the recent VIX behavior and its 72-month low? What does a low VIX mean for stocks?

VIX/S&P 500 in 2010

A low VIX in 2010 and 2011 always spelled trouble for stocks. On April 12, 2010 the VIX fell as low as 15.23. The S&P 500 topped on April 26 and dropped 17% thereafter.

VIX/S&P 500 in 2011

The same top and drop scenario happened in 2011. On April 20, 2011 the VIX moved as low as 14.30. The S&P 500 topped on May 2 and fell 21% thereafter.

VIX S&P 500 in 2012

In 2012 the VIX stair-stepped as low as 13.30 on August 17. The S&P didn’t top until September 14. Although the S&P corrected as much as 8.8%, the VIX barely moved higher. In fact it still traded at 13.67 on October 5.

What’s the takeaway? As the chart below illustrates, the VIX/S&P 500 correlation was a helpful timing tool in 2010 and 2011, but not in 2012. In fact, the VIX 2012 performance had little correlation to its historic seasonal pattern.

Better Use of the VIX

I’ve found it helpful to extract buy/sell signals via the VIX’s interaction with the Bollinger Band. On December 31 the VIX closed below the upper Bollinger Band.

The January 1, Profit Radar Report stated that: “This is a VIX sell signal and a buy signal for stocks.”

VIX/S&P 500 Outlook

The VIX closed near its high of the day yesterday, forming a possible reversal candle against a potentially bullish RSI divergence. The immediate down side for the VIX seems quite limited. Going long the VIX at current prices provides a much better risk/reward ratio than going short.

Trading the VIX is difficult as options suffer from time decay and futures from contango. VIX exchange traded products – like the iPath S&P 500 VIX ETN (VXX) and VelocityShares Daily Inverse VIX ETN (XIV) – provide exposure to the VIX, but suffer from the same problems as they use options and futures to replicate the VIX performance.

With or without setback, I expect the S&P 500 to labor a bit higher towards key resistance before a possible major reversal.

The Best Season For a VIX Trade

Forget “sell in May and go away,” the Thanksgiving VIX trade is statistically one of the biggest, if not the biggest, seasonal moves of the year. However, the year 2012 features one rarely seen caveat to VIX seasonality.

November/December is statistically the season for the best VIX trade of the year. On average, since 1990, the VIX drops 35% from Thanksgiving to Christmas.

The chart below illustrates the sharp VIX (Volatility Index) move from the November high to the December low. This year however, investors have to deal with a caveat.

No Slam Dunk – The VIX is in a Funk

The VIX is in a funk. How so? The VIX resisted the usual tendency to rise into Thanksgiving and is currently trading near its low for the year.

This is even more of a head scratcher considering that the S&P 500 (SPY) just dropped as much as 9.5%. Due to the inverse correlation between VIX and S&P, the VIX should have soared for much of November.

Quite to the contrary, the VIX actually dropped during the time the S&P fell hardest (November 7 – 16).

The table below shows the VIX closing price of the day before Thanksgiving and the pre-Christmas low (which has occurred between December 21 and 23 the past five years).

A measured 35% drop from this year’s pre-Thanksgiving close would draw the popular volatility measure below 10, a level last seen in February 2007. This isn’t impossible, but it’s improbable.

In short, the VIX trade doesn’t look like a high probability trade this season. Even at the best of times, it’s difficult to monetize moves of the fear index.

Tough to Profit from the VIX

That’s because the VIX itself can’t be traded. There are tradable vehicles that have been created, but they all have complex idiosyncrasies. Trading the VIX is almost like catching the wind. Many of those unseen idiosyncrasies cause price deterioration and make it difficult to capture profit.

The three vehicles that make trading the VIX possible are:

1) Options 2) Futures 3) ETFs/ETNs.

VIX options are subject to price decay. VIX futures usually find themselves in a state of contango or backwardation. VIX ETFs or ETNs are based on either VIX options or futures (futures are more commonly used).

Contango is a condition where the VIX futures (price of VIX in the future) trade at a higher price than the VIX spot price (current price). Contango is in essence a premium. The further away the expiration of the futures, the higher the premium.

Imagine buying a car and trying to sell it for a profit. As a private party you have to pay sales tax (7.25% in CA). If you buy a car for $10,000, you have to sell it for more than $10,725 (purchase price plus tax) to make a profit. Contango is like the sales tax.

Some research on the iPath S&P 500 VIX Short-term Futures ETN (VXX – the most heavily traded VIX ETN/ETF) suggests that the cost of contango is about 0.25% – 0.45% per day. Contango usually occurs when the VIX trades below 25.

When the VIX rises above 25 it usually suffers from backwardation. Backwardation is the opposite of contango, and happens when the spot price is higher than the front month futures. While contango eats into returns, backwardation can enhance the return of VXX.

VIX Lessons

While we likely won’t trade the VIX this year, the VIX research isn’t totally wasted.

The VIX suggests rising prices and some sort of a year-end rally.

This may provide trading opportunities for the S&P 500 and other equity indexes.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.