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Improve Your Volatility Trading By Listening To The Curve

Summary Successful volatility trading requires you to understand the futures curve. There’s more to the volatility curve than just contango and backwardation. The futures curve is telling you what the market believes about the duration of the disruption. This article is for intermediate volatility traders who already understand the various exchange-traded volatility instruments. Whenever volatility spikes, Seeking Alpha readers are presented with a spate of articles suggesting that they should go short volatility. Frequently, this is a good trade. But not today. If you learn to tell the difference between these situations, you can optimize your volatility trading returns. The past couple of weeks have been rough for volatility traders. After nearly four years of declining volatility, the broader markets decided that a long-expected correction was finally in order. Consequently, volatility spiked in mid-August and remains elevated to the time of this writing, gutting the typical short volatility trade (e.g., shorting VXX or UVXY , or going long their inverse instruments, XIV or SVXY ). Simple Volatility Trading Strategies Failed Unfortunately, over the past couple weeks, Seeking Alpha readers were bombarded with a series of articles with titles like (paraphrasing): Now is the Time to Short Volatility The Volatility Short is Ready Again Short Volatility Now Many of these articles are based on simple volatility trading strategies, such as: Go short when the VIX is above 20, or another magic number the trader happens to like. Exit when the VIX is below 14 or so. If you’re very brave and the VIX is very low (say 11 or 12), reverse and go long volatility. Other authors use the VIX futures curve and look at contango and backwardation. For instance: Go short whenever the futures curve goes into backwardation. Exit when it goes back into contango, possibly after a few days delay to eek out a better return. Some authors use standard stock indicators like MACD, stochastic, or RSI to detect elevated prices of VXX or UVXY and then go short, selling when those indicators return to “normal.” Still others recommend the reader just buy into XIV or SVXY and hold for a long period, ignoring the smaller spikes or using them as periodic entry opportunities. At some level, you can’t fault these authors. For the past few years, whenever volatility has spiked, going short volatility using one of these simple strategies has been a reasonable tactic. Unfortunately, readers who blindly followed these strategies during the last month have seen their positions crushed with massive losses. XIV is down more than 50 percent from its high in early August, for instance, and could easily fall another 50 percent over the next couple of weeks. XIV data by YCharts If you were unlucky enough to short UVXY a couple weeks ago, you saw it triple, and nearly quadruple at its recent high, possibly leading to margin calls and other unpleasant conversations. UVXY data by YCharts What happened? Could these losses have been avoided? The simple answer is “partially.” Most experienced volatility traders, myself included, lost some money during the first few days of the spike by going short. But for those in the know, it was small in comparison to what it would have been if we had held. These traders exited their positions quickly when it became apparent that this was not a short-term spike. Some, depending on their risk tolerance, may have actually made significant gains by reversing their positions and going long. What signs tipped them off? Listen to the Futures Curve If you’re going to take your volatility trading to the next level, you need to understand the futures curve. Most volatility traders know about vixcentral.com and use it to understand whether the futures curve is in contango or backwardation, but the analysis often stops there. The reality is, the futures curve is giving you information about the market consensus for volatility in the future (yes, I know that sounds obvious). First off, it’s important to remember that VIX futures act as a sort of insurance system for the equities markets. Traders who are long equities will often buy VIX futures as an “insurance policy” (a hedge) against rapid market drops just like those we’ve seen in August. Speculators typically take the opposite side of that trade, selling “insurance” and harvesting a risk premium when the markets are flat or up. It’s the time dimension of VIX futures that we’re most interested in for this article. Specifically, while the VIX may shoot skyward for any number of reasons, traders in the VIX futures market are always evaluating whether the market disruption causing the VIX spike is likely to be a short-term or long-term event. For instance, if the market believes that the disruption will be very temporary, then only the front month VIX contract will rise significantly and go into backwardation. Equities traders will buy a near-dated contract to best hedge their positions, pushing prices up. Short sellers (the insurance sellers) will demand more risk premium for the front month, allowing it to rise, but will still compete aggressively for the far-dated contracts, keeping those prices suppressed. When the market thinks the spike will be short-lived, the futures curve tends to look like this, from March 14, 2014: (click to enlarge) On the other hand, if the market believes the disruption will be longer term, more of the futures curve will go into backwardation. Equities traders will buy far-dated contracts to protect their positions out in time. Similarly, short-selling insurance salesmen will demand a greater premium for far-dated contracts to protect themselves. Thus, when the market thinks the disruption will be longer, the futures curve tends to look like this, from August 4, 2011. (click to enlarge) In extreme cases, the whole futures curve will go into backwardation. We saw this in 2008, for instance. This might be interpreted as the market saying, “We don’t have a clue when this is going to end. It’s just going to be bad for a long time.” During November of 2008, the curve looked like this: (click to enlarge) Lessons for Volatility Traders The main lesson here for volatility traders is that the shape of the futures curve is determined by the “wisdom of crowds” effect, with all traders in the market making an estimation about the duration of the market disturbance. The longer the perceived disturbance, the more months of the VIX futures curve that will be pushed into backwardation. There are a few important caveats here: The number of months of backwardation is only a rough indicator. It does not tell you exactly how long the duration will actually last. If the first two months are in backwardation, it doesn’t mean the disruption will last for two months. If we could predict the markets with that level of certainty, nobody would make any money as they would be perfectly efficient. The best you can say is that when just the front month VIX futures contract is in backwardation, the market currently believes (see the next point) the disruption will be relatively short. When more contracts are in backwardation, the market currently believes the disruption will be longer. Short-lived VIX spikes typically don’t drive the futures curve into more than a month, possibly two, of backwardation (I say “typically” because sometimes you will see multiple months of backwardation associated with a short spike, but it resolves itself within a day or two). Conversely, long-lived market disruptions like we saw in 2008 or 2011 force many more months of backwardation. The upshot is, when you see many months of backwardation in the curve, the futures is market is telling you to prepare for an extended period of volatility. The market consensus reflected in the shape of the futures curve changes day by day, minute by minute, as the market takes in more information. Typically, the front month contract will go into backwardation first and then subsequent months will go into backwardation as the market develops a belief that the disruption will be longer lasting. This may take place over days or even weeks. But the markets are also fickle. If new information arrives that suggests that what the market thought was going to be a long-term event will resolve itself quickly, you can see two or three months of backwardation go back into contango within a day or two. You need to watch carefully. This is why many volatility traders went short at the start of the August disruption; only the front month was in backwardation and it looked liked a temporary spike. Days later, the second and then the third month went into backwardation, suggesting that this was more than a short term event. Savvy volatility traders exited at that point, bruised but not bloodied. What About Buy and Hold? “But so what?” I hear many volatility traders say. “I sold short a couple weeks ago. Yea, I didn’t time it very well, but I’m not worried. The VIX is ‘mean reverting’ (not in a formal statistical sense) and it’ll eventually return to ‘normal’ and I’ll recoup my losses.” Is that a bad strategy? Well, the best that can be said is that these traders are probably right, but they are in for a rough ride. A buy and hold strategy for volatility is a lot like holding equities in 2007 and 2008 on the theory that the market always recovers. That’s probably true, but it can be a long, painful road back to break-even. Further, the opportunity cost during that time can be tremendous. Equities traders who exited the market in 2007 or early 2008, at the first sign of trouble, and didn’t reenter until mid-2009 recouped their small losses faster than those who held straight through the worst of it. Their returns remain far ahead of their buy-and-hold peers to this day. The same is true with volatility trading. If you can cut your losses short, bide your time, and then reenter the market when things are going your direction, you’ll be far ahead of those who hold through the worst of it. Also, remember that losses with exchange-traded short volatility products become “permanent” the longer the futures curve remains in backwardation. In other words, while the level of the VIX influences VIX futures, exchange-traded volatility instruments (e.g., VXX, UVXY, XIV, and SVXY) are really investing in a rolling set of VIX futures with a limited lifetime. If the duration of the disruption was large, then even if the VIX falls back to “normal,” the prices of these instruments will not return to where they were in early August. The share prices of the inverse instruments (XIV and SVXY) are “eaten away” by persistent backwardation during long-lived market disruptions. You may still have losses that will take you months or even years of persistent contango to recoup. Finally, every trader should remember that gains and losses are asymmetric . It takes a 100 percent gain to recover from a 50 percent loss and a 300 percent gain to recover from a 75 percent loss. What to Do Now If you recognized the signs and exited the market when this downturn started, congratulations. You probably walked away with a loss, but it could have been a lot worse. You’ll easily recoup that loss once the futures curve goes back into contango. If you bought in at the start of the spike, or even a week later, and then held to this point, you have a painful choice to make – sell or hang tough? You’re probably sitting on a large loss. Unfortunately, it’s impossible to tell whether it’s better to exit or to remain short. As of today, the first three months of the futures curve are in contango and the fourth month is flat (see figure, below). The fifth and sixth months are in backwardation and the seventh is flat. This suggests that this is going to be an extended period of volatility and we have some more pain still in store. You’re probably better off exiting and waiting for contango to return before you reenter. You might be even better off going long volatility (long VXX or UVXY) if the markets remain volatile. But be careful here! Volatility is very sensitive to market sentiment and going long against the natural short bias of volatility is always risky. There are no good answers here. (click to enlarge) In either case, make sure you listen to the volatility futures curve the next time and take appropriate action, swift and sure. Finally, if you’re interested in trading volatility, I invite you to follow me here at Seeking Alpha. Just click the “+ Follow” link up at the top of this post, by my name. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UVXY over the next 72 hours. (More…) 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.

Shorting Volatility Has Never Looked This Good

I wrote an article last week about shorting VXX but that turned out to be a bad idea. But given what has transpired in the markets since then, shorting volatility has never looked this favorable. An oversold market and historically strong VIX and VVIX rallies means volatility is extremely overbought and due for a move down. Last Friday I wrote an article about one of my favorite trading vehicles, the short term VIX ETF VXX (NYSEARCA: VXX ). I said at the time that with volatility spiking on the short end that history suggested that it was a good time to short VXX. When short volatility spikes VXX outperforms but that condition is always temporary. I also warned against further moves higher in VXX as it is a high risk/high reward strategy that can be gut-wrenching to endure. Well, we all know what has happened in the last couple of days and shorting VXX was a big mistake. But since the situation has materially changed since Friday’s pre-market, I feel a new look at the trade is warranted because there are now more compelling reasons to stick with the short and/or add to the position. My original idea was based solely on the fact that the VIX had spiked on the front end late last week as China began to dominate the headlines. The US market (NYSEARCA: SPY ) hadn’t yet seriously deteriorated and I incorrectly thought we had another run-of-the-mill mid-20s spike in the VIX on our hands, setting up a great short for VXX. Obviously, I was wrong and my short position on VXX has lost roughly 25% of its value in the last two days. So what has changed? The first and most obvious answer to that question is that VIX (and VXX) has continued to spike. The VIX has put on an impressive and in fact, historic rally in the last few trading days. Here’s a five year chart of the VIX; you can really appreciate the magnitude of the rally we’ve seen in the past few days when viewing it in historical context. (click to enlarge) One of the things that has changed since my original trade idea is that the VIX is heavily overbought. The VIX rarely reaches overbought on the 14 day RSI because it tends to spike and fall instead of rally. We’ve seen a rally in the last few days and that has sent VIX’ 14 day RSI to 89. That’s an extremely overbought level and that is one reason I think the short VXX trade is still a good idea. As VIX moderates we’ll see VXX move down. Whenever we’ve seen this kind of overbought condition in the VIX in the past five years we’ve seen it move sharply down over the ensuing days and weeks so there is no reason to think that won’t happen this time. The second condition that has changed since my last article is that the broader market is now oversold as well. Here is a similar five year chart of the SPY to show what I mean. (click to enlarge) We can see that the MACD and RSI are showing extreme oversold conditions that mirror only those of the late 2011 tantrum the market threw. Of course, after that subsided, we moved substantially higher. I don’t know that we’ll move substantially higher in the SPY but we don’t need that to happen for the short VXX trade to work out; we just need it to stop going down. Given the condition the market is in right now we are certainly due for a bounce. Third, the volatility of the VIX index, or VVIX, has also spiked to historical highs. Consider the events that have occurred in the past 10 years with the financial crisis being one of them and then ask yourself if today’s events are more concerning; I think the answer to that is a resounding ‘no’ so that makes the action in the VVIX even more perplexing. Here’s a five year chart of the VVIX to illustrate my point. The VVIX actually exceeded 200 during yesterday’s action, a number that has never been reached before. Even recent panics in the market have caused VVIX to spike to the 120 or 130 area so cresting 200 is quite extraordinary. That tells me there is excessive panic in the market and that condition cannot persist. By definition, panic is temporary. Given all of this and the original trade idea that VXX cannot stay elevated forever, I think the evidence that VXX should fall in the coming days or weeks is quite compelling. We have a VIX and VVIX that are both extremely overbought after historical rallies and a broader market that is begging to rally. I don’t know if we’ll retake the highs on the SPY this year but as I said, we don’t need that to happen for short VXX to work. The panic will subside at some point and VXX will tank again; it always does. The ride to get there is bumpy and stomach-churning but the rewards can be great. Please understand that despite how good the setup looks a short VXX can still go wrong in a hurry – as we’ve seen since I recommended it on Friday – but the odds of a favorable result are exponentially higher now than they were on Friday. I just wish I had waited. Disclosure: I am/we are short VXX. (More…) 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.

Time To Short Volatility Again

VXX has spiked in recent days on China fears. But I think the conditions for a short of VXX have been met. Contango has disappeared and that has been a reliable signal in the past. I’ve written several times in 2015 about volatility and specifically, shorting the popular short term VIX ETF proxy VXX (NYSEARCA: VXX ) as I’ve taken the occasion of various spikes to bet on normalization. Last time I wrote about such a trade it was during the July meltdown stemming from the now-distant Greek crisis and that trade returned very nice profits, as you can see below. Well, here we are again as the VXX is spiking once more on China’s woes or any other global event investors can think of. (click to enlarge) My basic premise for entering a short VXX trade is pretty simple; wait for a spike in VXX, assess the reasonableness for a sustained higher VIX level and if there is none, short VXX. It really isn’t more complicated than that. VXX is a great vehicle to short because of its famous contango. It costs money (most of the time) to hold VXX due to contango so the opposite of that is that shorting it has a natural tailwind. This is the second cue for me in knowing when to short VXX and when to wait for a better entry point. But first, let’s assess why the VIX is spiking. Seems to me market participants are up in arms about China’s most recent meltdown and while that’s fine, just like the Greek crisis, I believe fears are overblown here. S&P earnings are also suffering somewhat and the market is losing leadership in a lot of ways so for me, that is a much bigger problem than China’s latest bubble popping. I know there are many people that would disagree with me but I just don’t get it on China. Therefore, the first condition of my short signal has been met; the reason for the spike seems improper and in particular, the magnitude with which VXX has spiked. We’re up double digits in two days on the VXX and for what? The second signal I mentioned is when VXX is no longer in contango, that has historically been a great time to short it. I like to use VIX Central to chart the VIX curve and determine the level of contango because it makes it easy for even novice VIX watchers to understand what is happening. I’ve pulled two charts from VIX Central below to illustrate my point. This first chart is a straight look at the VIX curve. Since the VXX deals with short term VIX contracts, we’re really only interested in the first two months. As you can see, as of yesterday’s close September and October were at exactly the same level and even November and December were only pennies higher than the front month. That means contango has disappeared and when that has happened in the past, it was a great time to short VXX. This chart shows the level of contango between the first and second month VIX contracts for the past several years and as you can see, flat contango and backwardation are rare. But when either of those conditions are met, we are usually due for a sell-off in front month VIX. That means that when we reach the level of contango we are at right now (zero, the red line on the chart), while we may move a little higher, history suggests the odds are heavily in favor of shorting VXX right now. So here’s the setup; the SPY just hit a six month low yesterday and after the beating the market has taken in the last couple of days, I think today will be a flat to lower day. That means VXX will probably be higher on Friday and that is where I will make my short. I will use the recent spike in VXX to short it as I think we are nearing the top of this particular spike. Now, I’ll make my standard VXX trade disclaimer because I don’t want anyone to get the wrong impression. Trading VXX is very risky and extremely volatile and thus, you must understand that the potential reward is high but so is potential risk. Please understand what you’re doing before taking a long or short position in VXX because it moves around a lot and can make or lose you a lot of money in a very short amount of time. I’ve been on both sides of VXX trades and I can tell you it can wipe out a lot of value quickly. The odds are in favor of a VXX short right now and I think today is the perfect opportunity to take a short position in VXX given that the spike in volatility seems overblown. I also think the market is near a base and will rally from here so that is also a favorable setup for shorting VXX. This position is not without risk but given the setup we have now, VXX shorts are heavily favored here. Good luck out there. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in VXX over the next 72 hours. (More…) 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.