UVXY To Continue Falling Due To Roll Yield

ETFS

As you can see in the following chart, the ProShares Ultra VIX Short-Term Futures ETF (UVXY) has continued to hit fresh lows in a multi-month downtrend.

Despite the decline in UVXY, I am still bearish volatility. Specifically, it is my belief that while the odds favor a bounce in the VIX in the short term, in the long term, the numbers are overwhelmingly against an investment in UVXY.

Volatility Markets

Let’s start this piece off with a technical look at the S&P 500.

In a move which continues to confound many market participants, the S&P 500 remains bullish. As you can see in the above chart, the market has continued to push towards new highs in the immediate trend as well as approach all-time highs.

However, if you look at the MACD under the chart, there is potentially some cause for concern in the overall health of the trend. For example, the MACD shows that momentum has waned somewhat over the past week with the latest readings approaching a bearish inflection point.

How I interpret this data is that the market is likely going to push into new highs over the next few trading days; however, the underlying momentum is likely going to wane and we will see the market roll over into a pullback. It is of course too soon to tell if the next pullback will be a broad-scale correction; however, I believe we can conservatively say that over the next week, the odds favor at minimum a shallow pullback against the larger trend.

What’s this have to do with the VIX? Glad you asked. The reason why it’s important to monitor the trend and strength of the market is that the VIX and the S&P 500 are directly and inversely correlated: as the market falls, the VIX rises.

I have used this chart many times when talking about VIX movements for one simple reason: it is very, very important to understand that the VIX is highly responsive to drops in the market. Additionally, the degree of correlation is directly proportional to the time window across which you are observing: the shorter the time period, the greater the responsiveness seen in the VIX.

What this data essentially says is that if you are aware of what is going to happen in the S&P 500 on a short-term basis, you implicitly have a view on the VIX with a high degree of conviction. In other words, time the market correctly and you can time the VIX.

It is of course difficult to time the market; however, I believe that the waning momentum coupled with the prolonged trend should put traders on the defensive at these levels. In other words, since I am moderately bearish the S&P 500 over the next 1-2 weeks, I am therefore moderately bullish the VIX over this time frame.

This said, however, there are very clear seasonal patterns which also put me on watch when it comes to trading the VIX. The first of these is the standard deviation seen in the VIX by time of the year.

Put simply, we are entering a period in which volatility tends to rise and it tends to do so dramatically. Historically speaking, the months of October and November tend to be the most volatile months for volatility with several historic pullbacks in the market happening during this time frame.

As you can see in the following chart, this heightened volatility tends to be to the upside with the average level of the VIX increasing between now and October/November fairly reliably over the past few decades.

From a purely statistical standpoint, selling the VIX at this level isn’t really the best play. Put simply, we are fairly close to the long-run mean level of around 19 and the numbers suggest that we’ve got seasonal tailwinds which will likely prop up the VIX. Not only is this the case, but the numbers also indicate that election years tend to see some degree of an uptick in volatility.

It’s hard to draw too many conclusions from the above data set in that two of the data points (2008 and 2000) occurred either during or before significant financial crises. However, what we can say is that when considered in aggregate, the VIX has rallied in four of the last six election years between now and the end of the year. Will it be different this time? I don’t know, but I believe the data suggests that both seasonality as well as the moderate election year effect will see volatility rally somewhat throughout the remainder of the year.

All this said, however, I am still bearish UVXY. As we’ll discuss in the next section, there is a very large difference between taking a view in the VIX and trading UVXY which is precisely why I am short and recommend getting short UVXY.

About UVXY

Let’s jump straight to the chase here. UVXY is an instrument which tracks the S&P 500 VIX Short-Term Futures Index on a 1.5x leveraged basis and this index has dropped by about half per year over the last decade.

This honestly should be a complete full stop for most investors considering allocating capital to UVXY. Put simply, UVXY remains one of the worst performing financial assets in the world for its market cap with time periods as short as 2-3 years seeing 95% or more of money removed from shareholders… regularly.

There is no saving grace here: UVXY has annihilated wealth and continues to do so. The reason here is quite simple: when you’re trading UVXY you’re actually trading VIX futures which are generally priced above the spot level of the VIX. And as you can see in the below chart, this means that through time you are losing value as these futures contracts converge to the spot level of the VIX.

Contango seems to be natural state of the VIX markets (with about 85% of all days for the past decade seeing spot prices below the futures market). This means that on average, we should continue to see wealth removed from shareholders of UVXY: through time it is holding futures priced above spot and these futures are converging towards spot during a trading month, resulting in consistent drag upon returns. Put simply, the longer you hold UVXY, the greater the degree to which you will underperform an investment in the VIX itself.

For this reason, I am quite bearish and short UVXY using long-dated puts. I believe that this relationship is unambiguously clear: UVXY is consistently losing money due to futures convergence which means that it should only ever be used for short-term speculative purposes or as part of a larger hedging strategy in my opinion. This has me structurally bearish the ETF and I will actively look to be adding to a short position should we see the bullish VIX thesis in the prior section unfold.

Conclusion

The S&P 500 is likely headed for a pullback as momentum wanes near all-time highs. Seasonal factors suggest that the VIX is going to rally between now and the end of the year. Despite the somewhat bullish VIX data, the odds strongly suggest long-term short plays on UVXY.

Disclosure: I am/we are short UVXY. 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.

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