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BETTING AGAINST A BLACK SWAN THE -1X SHORT VIX FUTURES ETF I Think This Is The Best Trade EVER
Volatility creates emotion—anxiety, fear etc. You’re supposed to keep emotions out of investing. Maybe that’s why the volatility trade—VXX-NYSE–has been one of the worst of the last decade. Look at this chart:
So doesn’t an anti-volatility play make A LOT of sense? That would be the 1x Short VIX Futures ETF—SVIX-NYSE. This is an equity that you go LONG to be SHORT. I’ll try to make it simple here, because a) it is and b) this could be the best trade I have ever seen in my life.https://www.volatilityshares.com/svixLet’s back up to last Monday, August 5. That was a BIG down day in the stock market.
I’ll explain what I think happened last week, and why I think the SVIX is the best way to take advantage of it. But before I do (which will necessarily get into the weeds), let me put this trade in simple terms.
I don’t know if the market decline is over. It might be. It might not. There are plenty to worries about the economy. A Harris Presidency isn’t great for stocks. Harris would continue to be tough on M&A, rejecting deals from getting done. Also expect more wage support, including higher minimum wages, which could follow through into inflation.
The indexes remain expensive levels compared to history even after the drop we’ve had.
So, there are lots of reasons to worry about a stock market decline.
What I am betting on here is not that. This bet is on the speed of the decline. Last Monday we saw the S&P down some 5% at one point, I am a betting that the decline going forward will be more measured – more orderly.
The best way to play that is with the SVIX. Here is why.
WHAT THE HECK HAPPENED
ON MONDAY AUG 5?
If you were like me, when you woke up last Monday morning you had a bit of a holy moly moment. My first look of the market was seeing the S&P down nearly 5% and the NIKKEI (the Japanese index) down 11% overnight!
Source: Stockcharts.comAn 11% move for an index is EXTRAORDINARY. It is almost hard to fathom such a large, broad move.Obviously, I had to figure out what was going on. But I already had my suspicions.
See, what I had begun to notice the week before was that the Japanese Yen (Japan’s currency), was going up every day.
Source: Stockcharts.comBig moves in currencies is typically nothing to worry about. But the Yen is different.Japan has EXTREMELY low interest rates. For years they have been essentially 0.
Because of that the Yen is the preferred currency for borrowing money. Hedge funds and other traders love to borrow in Yen, sell those yen for another currency (usually the USD) and invest the funds in something else, usually trades that deliver a consistent daily return.
These sorts of trades are commonly called “carry trades”. The term carry trade became a lot more common last week as everyone tried to make sense of Monday’s drop. But carry trades are nothing new. They also are often responsible for the sudden, out of the blue, market drops we see.
Monday was no exception.
While a carry trade is expanding, the Yen is typically weak, because traders are selling the Yen they borrow to buy other currencies so they can make their investments.
But when a carry trade unwinds, the Yen tends to strengthen suddenly. Traders and funds rush for to exit at the same time, in the process buying back Yen to close their loans.
Which is what we started to see a couple weeks ago, and what reached a crescendo on Monday.
The thing about this sort of unwind is that it’s not really “real”.
Here’s what I mean by that. In the last week I’m sure you’ve heard the talking heads talk about stocks being expensive, about the economy weakening, giving a whole list of reasons for the market decline.
But the kind of move that we saw on Monday wasn’t really any of that. Sure, all these things helped create the conditions for the unwind. But the move itself was just a giant unwind of a levered carry trade.
Why do I say this isn’t “real”?
Because once the trade is unwound, that big sudden move down ends. While that doesn’t mean the market won’t decline more, it does mean the violence of the decline has seen its peak.
That’s what my SVIX trade is all about: the end of the violent decline. Here is how it works.
VOLATILITY – MEASURING INVESTOR FEAR
Volatility is a measure of the premium investors are willing to pay for puts on the S&P.Puts are options that bet something will go down. Because most investors are trend followers, as a market decline accelerates, more investors buy puts on the market and the premium they are will to pay goes up. The biggest and most liquid market to buy puts on is the S&P 500. Therefore, tracking the premium investors are willing to pay for puts on the S&P 500 is a useful measure of how worried the market is – or how volatile.The practical measure of this put option premium is the VIX index. On Monday, when the S&P declined sharply, put premiums on the S&P went way up (as investors got worried and wanted to buy puts to protect themselves). The VIX spiked to as much as 65.
Source: Stockcharts.comIn practice, the VIX index behaves like a speedometer that measures the speed of a market decline. The faster the market goes down, the higher the VIX will go.Conversely, when the market is not under attack, which is most of the time, the premium for S&P puts is not particularly high, and the value of VIX is low.
Here is an important consequence for this trade: the market can decline and the VIX can still go down so long as the market goes down more slowly.
Which is what I’m betting on with this trade.
What we saw on Monday morning was something like an earthquake. The market survived that earthquake. There will be aftershocks, and it is quite possible that the bottom of the market isn’t even in, but the chances are that we have already seen the high in terms of the speed of the decline – which should correspond to the high in the VIX.
For all I know the market has 10% or more downside. But you know what? With this trade I don’t care. The call I am making is simply on the speed of the correction.
As the decline slows, you’ll see the VIX index come down. And the SVIX go up.
CASHING IN ON “THE ROLL”
That is the first part of the trade – a decline in the velocity of fear. But there is a second part as well – it has to do with the forward curve of the VIX.Let’s start by looking at how the SVIX works. The SVIX is an exchange traded fund. It tracks the inverse of volatility to the VIX by buying future contracts and swaps on the VIX.Here’s the key point: VIX future contracts are chronically in contango. That means that the price of a second month contract trades above the price of near month contract (the opposite is called backwardation; these terms are mostly used in ETFs and commodities. VIX futures are RARELY in backwardation).
If you owned a product that was long the VIX (there is one, its symbol is VXX), this would be a BAD THING. The VXX contract is always having to maintain its position in the VIX, and to do that it sells the near month at the lower price and buy the second month at a higher price. This is called rolling its contracts and it does it to maintain a 30-day maturity target. Those rolls are constantly losing money because of the contango.
We express that by saying–over time, the VXX experiences natural decay. Over the last years, the 10 year average VIX contango is 5% per month.
Not so with SVIX. In fact, the opposite plays out. Because the SVIX is inverse the VIX, it benefits from the contango.
If the index goes nowhere, the SVIX gains by its purchase of the 2nd month and sales of the first month contract. On average this is a gain of just over 5% per month. In other words, if nothing else happens, the SVIX makes money every month. This is what I call a “structural advantage” in this trade, and it is INCREDIBLY POWERFUL for SVIX.
If you have wrapped your head around this and decided that’s a good thing, you’d be right!
Longer term, this dynamic is why the pros consider the VIX to be an ‘investment grade short’. It has declined 82.5% over the
past three years and 18.2% over the past year – and that is after the big spike we saw on Monday.
As for the SVIX, well it is the opposite. I’d call it an “investment grade long“!
Imagine Wall Street creating a financial product that structurally BENEFITS investors—this is it!
THE BIG RISK IS A BLACK SWAN
The risk with this trade is simple – an “exogenous event”.That’s a $5 word for saying something bad happens out of the blue. This trade blows up if there is a real earthquake somewhere, if there is a sudden nuclear escalation in the Middle East or if China goes rogue and attacks Taiwan.In those scenarios, the VIX spikes again and the SVIX goes south FAST.
It is essentially the risk of every carry trade. Carry trades all amount to a bet that everything stays status quo.
There is a reason so many investors pile into them. It is because almost all of the time, nothing happens.
What I like about my timing here is we are putting the trade on right after an event. Its rare to sustain the level of volatility you had from the first spike. For that to happen, you need a scenario like what happened with COVID, a sustained threat to the global economy.
I don’t think we have that today. We have plenty to worry about to be sure and there are lots of reasons for the market to tread water here or even slip a little more. There is also always a sharp punch up or two after events like Monday, after shocks, and we probably won’t go down to a 12 VIX or a 15 VIX even anytime soon.
But over time, the VIX will come down. The SVIX will go up. And this trade will make money.
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Keith
