Financial markets have been very quiet over the past two months. The S&P 500 is up about 2% while gold and long-term bonds are down a few points. It is eerily quiet considering we are just two weeks away from one of the most contentious elections in U.S history. Not only that, but economic data has also been very volatile, we are back in earnings season, and the possibility of a stimulus bill seems to change by the hour. Despite this, there is very little action and it seems most investors are in a “wait and see” mode.
Personally, I believe it is best to act when everyone else is waiting on the sidelines. There are many catalysts today that could cause very extreme moves in stocks, it is best to make necessary changes before those catalysts occur as the price changes will likely be rapid and significant. Such a shock would create a spike in fear which often causes poor financial decisions.
Overall, I’d take the bearish bet on equities today. This could change, but the rising yield-curve is generally associated with a decline in stocks. Additionally, the persistence in initial jobless claims (and rising permanent unemployment) as well as poorer-than-expected industrial production increase the likelihood of poorer-than-expected earnings. This may not be true for all sectors like financials (which was hit the hardest early on, setting low expectations), but I see poor earnings as likely for technology companies since expectations are extremely high today.
Even still, it is possible equities break higher from here in a “blow-off top” pattern. This could happen without an improvement in fundamentals, it would only take enough short-sellers to be squeezed and a spike in speculative buying activity. Again, I believe these two catalysts have already occurred, but they could reoccur. If it happened again, it could come with a rise in the VIX volatility index. If markets fall, the VIX index will almost certainly rise. This creates a strong alpha-opportunity in the VIX ETF (VXX).
What Exactly Does VXX Own?
First, let’s refresh on what exactly the VIX and VXX are. We must know exactly what we’re buying. The VIX is an index which measures “implied volatility” on the S&P 500. This is based on option prices. When investors are concerned about a crash, they buy put options for protection/”insurance” which causes put prices to rise.
This directly increases “implied volatility” which is simply the calculated “expected” volatility (annualized standard deviation in returns) of the S&P 500. VIX is at 28 today which generally means investors expect the S&P 500 to be within 28% of its current level a year from now (specifically, a 68% chance of it being +/- 28% from the current level). It is important to note that the “VIX” is a short-term measure based on annualized 30-day expected volatility, the annual VIX is slightly higher.
The VIX index is a measure, but it has been made into a futures contract, so investors can speculate on it. VXX owns these futures contracts and rolls them each month. In reality, these futures essentially like buying an ATM straddle option (a put and call together) on the S&P 500 and rolling it on a daily basis. This creates drag and losses over time, but extreme gains during times of higher expected volatility (most notably, market crashes).
VXX Is Poised For a Breakout
This year has seen a significant amount of market volatility. There was an extreme and rapid crash during March followed by an equally extreme and rapid recovery. VXX has declined back toward pre-COVID levels. The VIX index is also much lower than it was. See below:
Still, the VIX index is not necessarily low and is about 50% above its normal “bull market” levels. The VIX index is tightly correlated to drawdowns in the S&P 500 since the demand for protection rises when the market declines. This is shown in the chart below which uses daily data for the S&P 500’s drawdown and the VIX since 1990:
(Data Source – Federal Reserve)
Over the past three decades, a 1% drawdown usually causes the VIX to rise 0.45. However, the relationship has been much stronger since 2019 and currently, a 1% drawdown is associated with a 1.5 increase in the VIX. This is very important since it implies there may be a lot of pent up fear in markets and potential overleveraging in option/derivative markets. In fact, the extreme increase in the popularity of ‘short volatility’ strategies over the past few years has been a major culprit in VIX spikes.
As you can see below, the slope between the VIX and S&P 500 drawdown has risen significantly since the 2008 crash:
(Data Source – Federal Reserve)
From 1990 to about 2010, a 1% drawdown was associated with a roughly 0.5 increase in the VIX. However, the relationship has become stronger almost every year since then with it rising to a staggering 2.5 by 2018. It may have peaked in 2018 during the “Volmageddon” crash which saw short-VIX ETFs like SVXY lose 90%+ of their value overnight. That said, the relationship is still much stronger than normal which implies a small crash could easily bring VXX much higher.
The S&P 500 is currently within a few points of its pre-COVID level and has been unable to break above this level for about two months. If there is a failure to reach stimulus, a wave of poorer-than-expected earnings/economic data, a negative election surprise, a continued increase in the yield curve, or more vaccine delays, it would likely spark another wave of drawdowns. A confluence of all potential catalysts is unlikely, but it would likely only take one or two to trigger renewed drawdowns. Of those, election and stimulus-related volatility are likely to have the biggest impact.
The Bottom Line
The near-term potential losses in VXX are about 30%. This is based on a slide back to pre-COVID levels. However, if there is a 10-30% drawdown in the S&P 500, it could cause VXX to rise 150-450% (based on 1.5 VIX to drawdown relationship). Of course, it is also hypothetically possible that VXX rises with the S&P 500 due to a potential surge in call-buying activity (likely due to speculation or gamma short-squeezes). This has recently been seen in many major technology companies (notably Apple), but it is rare in the S&P 500. Still, since this phenomenon is occurring today which limits potential losses in VXX.
VXX is no doubt a more speculative asset and tends to “rise like an elevator and fall like an escalator”. It has been falling for some time despite a rise in market catalysts which I believe makes for a great short-term trade opportunity in VXX. This trade could also allow many investors to hedge against losses and remain long. Position sizing should be limited due to VXX’s long-term decay, but it seems VXX has a very favorable upside potential over the next two months (until year-end).
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: Long volatility via Nasdaq 100 straddle option