At the time of writing, the ProShares VIX Short-Term Futures ETF (VIXY) is having its strongest day in a few weeks as the VIX has risen by over 15% on the back of a sliding stock market.
While we may continue to see some uplift in VIXY due to seasonal factors, I believe that this current rally will prove to be a great long-term selling opportunity. It is my belief that now is a strong time to sell the ETF for all but the shortest-term investors.
To start this piece off, I’d like to frame up the recent movements in the VIX to get an idea as per where the index could likely travel over the coming weeks.
As you can see in the chart above, the VIX is currently pushing into the highest levels seen since early September. This rise in the VIX is associated with a clear decline in the S&P 500 as the market seems to have been caught off its feet by the rising virus count as well as stalling stimulus discussions.
It is times like these that investors may be tempted to jump on the growing momentum of the VIX through buying VIXY. I believe this would be the wrong move at this point because the numbers suggest that now is actually a strong selling opportunity.
One study which clearly suggests that the VIX is likely going to decline in the coming days and weeks is the historic market tendencies showing the mean-reverting nature of VIX movements.
In this study, I have calculated the historic probability that the VIX is higher or lower a certain number of days into the future after the VIX hits a 1-month high or a 1-month low. For example, at the time of writing, the VIX is currently hitting a new 1-month high. This above study would say that since 1991, when the VIX has hit new 1-month highs, there’s about a 70% chance that it’ll be lower a month later. In other words, this calculation clearly shows that there’s a strong chance that now is actually a good time to sell rather than to buy – since the VIX is hitting new highs, the data shows that we’ll likely see the VIX head lower from here.
Another study which captures the future probabilities fairly well is the clear correlation between the outright level of the VIX and future VIX movements.
At present, the VIX is sitting at a little over 31 points. Historically speaking, when the VIX is at this level, it tends to signal lower levels over the next month with the data since 1991 showing about a 76% chance that the VIX turn negative. And on average, this decline is around 7-10% suggesting that within the next month, we’ll see a good portion of the current movement retraced.
It’s important to remember that these are just average studies of history probabilities. While the data says that there’s a pretty good chance (around 70%) that the VIX will turn lower over the next month, there certainly is a case to be made that we may continue to see a few weeks of upside due to seasonal tendencies.
In this chart, I’ve calculated the history volatility of the VIX by month using about 27 years of data. What the data shows is that on average, the VIX is most volatile in October with history showing some carry over into November. Additionally, as can be seen in the following chart, this volatility reflects through to higher levels of the VIX in this time of the year.
Put simply, I believe this data shows a clear tendency in that we are in a time of the year which historically has shown peak volatility.
How I interpret this data in light of the recent market action is that what we are seeing now is in line with historic tendencies – however, the data also suggests that we’ll see a tapering of volatility from now through the end of the year. In other words, even though history would show that we can expect late October/early November to be volatile; the data also shows that on average volatility declines from around these weeks through the end of the year.
So while it’s entirely possible that we’ll see a few more days of upside in the VIX, I believe hindsight will show that selling now is probably the best move. The short-term odds suggest that the VIX is probably going to fall over the next month while seasonality shows that we are around the peak levels seen in most years. In other words, it’s a good time to sell the VIX.
While the VIX itself is likely turning quite bearish at these levels, I believe that we need to draw a firm line and make a clear distinction between an investment in the VIX and an investment in VIXY. The reason for this is simple: VIXY is only correlated to changes in the VIX over the shortest of time periods.
Put simply, VIXY is actually not tracking or holding the VIX, so its returns will not directly correlate with the movement in the VIX. Instead, VIXY is holding VIXY futures – instruments which settle off of the VIX values at a later date. It is utilizing something called the S&P 500 Short-Term VIX Futures Index, which is an index provided by S&P Global.
The above chart shows the correlation between this index and the VIX over a certain number of holding days, using the last 10 years of data. This chart shows a very simple theme: the longer that you hold VIXY, the less of a degree that the returns you earn will be correlated with the returns seen in the VIX. For a case in point: at the time of writing, the VIX is up 15% while VIXY is only up 6%. In other words, just looking at a single day shows a dramatic divergence of performance of around 9%.
This divergence in performance is due to the fact that VIXY is holding VIX futures and not the VIX itself. And there’s an interesting tendency with VIX futures holdings: they tend to lag movements in the spot market in relation to how much length is left until expiry.
This chart shows the percent differential between a few different futures contracts and the spot level of the VIX, given specific VIX levels over the past 10 years. There is a clear trend at work in the data in that the stronger the VIX level, the greater the degree of underperformance in VIX futures, with longer duration futures seeing the greater levels of lag.
What this data means is that when the VIX rises, it tends to outpace future contracts, regardless of duration (however, the degree to which the VIX outperforms is correlated with the duration of the futures contract). This explains why today’s performance in VIXY is lagging the outright change in the VIX.
However, there’s another key factor explaining the long-term lack of correlation between the VIX itself and an investment in VIXY and that reason is called “roll yield”. Roll yield is the return you earn when you hold a futures contract and it convergences towards the spot market. This relationship can be seen in the following chart.
This chart shows the average level of the VIX and the front two futures contracts (the contracts VIXY holds). What this shows is that on average VIX futures contracts are priced above the spot level of the VIX and on average, futures converge towards spot. If you think through VIXY’s holdings, this means that in a typical month, VIXY is holding futures contracts which are priced above the spot level of the VIX and on average these futures are slowly declining towards the spot level in a normal month.
When you consider the fact that VIX futures contracts have been in contango about 85% of all days over the past decade, the case for VIXY becomes quite bearish. Since VIXY is holding futures which are largely priced over the spot market and since these futures are converging towards the spot by falling, this amounts to sizable losses for VIXY traders through time with the past 10 years seeing its index fall at about 50% per year. This is why there’s a clear lag in performance between this index and the VIX with longer term holdings seeing greater losses against the VIX.
I believe this is the clear and compelling case for VIXY. Since its index is exposed to roll yield, this means that today’s elevated level of the VIX makes for a strong shorting opportunity to capture this long-term trend. This is why I’m bearish VIXY.
For trading VIXY, I don’t recommend an outright short position without firm risk management through options in place. My preferred trade is to buy puts or put spreads. The VIX can sizably move against short traders and a thesis which plays out over the long run can see significant heat against initial positions. For that reason, I believe that options are the best way to play this instrument and I’d look to buy puts or put spreads (buy a close to money put, sell a further out of the money put) 1 year out or more to capture this roll yield return.
The VIX has surged strongly due to a selloff in the S&P 500 which seems to be driven by rising virus cases and lagging stimulus discussions. Historic data suggests that there’s perhaps a 70% chance that the VIX will turn negative over the next month. VIXY trades VIX futures which subjects holders to lower correlations with the VIX as well as roll yield losses.
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.