The VIX complex, and to a lesser extent the S&P 500 options, were completely thrown off by the move in the VIX futures on Monday caused by buying algorithms triggered around the VIX ETPs, VelocityShares Daily Inverse VIX ST ETN (XIV) and ProShares Short VIX Short-Term Futures (SVXY) .
We have seen algorithms feed on themselves in the past and will likely see algos feed on them again. But how does one trade this space after it's been put through a meat grinder like the VIX and the VIX ETPs were? The answer is to analyze what happened, think about how the space has changed, and develop a plan. We took care of step one yesterday, so what about steps 2 and 3?
What has changed between Monday and now? The obvious answer is that XIV is going to go the way of the dodo and SVXY is a $12 ETP. The less obvious answer lies in the marketplace.
Despite all the moral platitudes about how evil these products are, the facts are they did what they said they would do. The fact that a bunch of the world did not understand the risk of these products is really what happened.
Selling premium via XIV, SVXY, option selling, or owning puts in the iPath S&P 500 VIX ST Futures ETN (VXX) put has been the layup of a trade for three years. However, think about this: If there is a seller, there has to be a buyer, so who were these buyers? The short answer is hedgers -- hedgers using puts and VIX options and VIX futures. In addition to them, the excess vol selling (and there has been for the last year) was picked up by market makers.
I was a market maker for years and still talk to the guys in the SPX pit. Over the last year all they did was buy at-the-money (ATM) and out-of-the-money (OTM) puts spreads and buy OTM calls. We saw this because the VIX hung below 10 a lot last year and had its single lowest average annual VIX ever.
We saw this in the VIX futures and options markets as well. The Contango in VIX futures (the discount spread between the VIX cash index and VIX futures) tightened significantly as the year dragged on. As it tightened, vol sellers moved to other months to flatten and take advantage of that volatility.
All of this action contributed to XIV and SVXY going up and up, making them more attractive to the uneducated, and thus providing even more short vol for the market to swallow.
This relationship is now gone. XIV is off the market, SVXY traders are licking their wounds and far less likely to pile into the ETP (by the way, a firm bought $500 million SVXY on Friday....ouch).
Several funds have blown up: LJM is gone; Nomura's vol fund is gone. I heard the story of a prop shop that is likely to go belly up because traders thought SVXY couldn't lose long term. In addition, all of the put sellers that were in the SPX are gone or at a minimum less active in the market.
There was a lot of scrambling to cover last week and this week. All of the excess risk sellers have been sent packing. Essentially, there are far fewer risk sellers than there were this time last week.
For those of us that were not "volatility tourists," dumping volatility and ignoring the risk, the market is a much better place. The risk premium in SPX put options is back. The risk premium in the VIX futures and the VIX options is back. Right now, premiums are so high that the VIX market is in a full backwardation (VIX cash index is higher than the futures). This is rare and a time where there is money to be had from the market.
Stocks get oversold, hedges get overbought, and VIX goes way too high relative to what ends up being the actual risk. Thus, I would argue that after the XIV blowup, this is the first time in a long while there is a decent reason to be short some volatility risk premium. I am not suggesting backing up the truck, but for those of us that saw this train wreck coming, and did not jump the vol-selling bandwagon whole hog, now is the time to start dipping the toe in the water.
So here are a few ideas:
- Enter the original vol-selling trade... buy stocks. When you long the market you are a natural short, the S&P 500 just discounted all the gains from the tax cut. Some might say "bubble," I say why not put some of that cash allocation to work (you know the kind you set aside when the S&P 500 got to 2850)?
- Sell OTM puts in SPDR S&P 500 ETF (SPY) or SPX to get long the market. If you think prices are still too rich (I'm not here to argue), with the pop in vol the March SPY 260 puts can be sold at over $3.00 a contract. That would get the seller "put too" at 257 in SPY. Again, I am not a stock analyst but if we are selling off simply because of interest rate and inflation fears... (remember when that was why we were down?
- Dip your toe in SVXY: With the VIX future now over 20 what happened on Monday has become much more difficult. In addition, the share price is $13.00; 500 shares costs $6,500, and could easily be worth $10,000 if the VIX eventually normalizes and with some time. As the ETP runs take money off the table (something many XIV investors did not do).
- Buy longer-dated puts in VIX or VXX. With implied volatility (IV) high, VXX was briefly about its pre-split price. While it's back to $43, remember it was $27.00 last Friday. The same holds for VIX: March 15 puts cost about $1.30, so if VIX settles back to 12, those would be a great purchase.
At this point with the VIX backward, stock returns have historically been somewhat negative in the short term. However, with a long-term view, they have almost unilaterally been buying opportunities/vol-selling opportunities. I think this will be the case with this selloff. The key is to practice risk control, money management, and trade management. Basically, don't go in too big, too fast.
There are a lot of people crying foul of the ETPs that just blew up. There are things that could have been done better, but there is nothing wrong with these...they do serve a purpose. Those that got a lesson on what that purpose is (being the counter-party to a vol event) just opened the door for smart investors. It's time to step up and give the market what it needs.
Mark Sebastian is a regular contributor to Real Money Pro, our site for active traders. Click here to get daily market commentary and trade ideas from Mark Sebastian, Paul Price, Doug Kass and many others.