Volatility bulls still haven't thrown in the towel, based on fund flows data
The following is a reprint of the market commentary from the August 2017 edition of The Option Advisor, published on July 28. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.
After the CBOE Volatility Index (VIX) fell Wednesday to a new all-time low -- and, in the process, extended a record-setting streak below the 10 level -- a Seeking Alpha headline hit the wires that seemed to effectively sum up Wall Street's collective response: "Volatility Has to Go Up Now, Right?"
It's an entirely reasonable question, given VIX's well-known tendency to revert to the mean. But at the same time, the expectation that VIX is surely due to rocket higher has been pervasive throughout most of 2017, even as the volatility gauge has trundled steadily lower. With the VIX pacing for its lowest average reading in history this year, the question in the headline quoted above seems not entirely rhetorical.
And against this backdrop, it now seems that VIX may even be taking a pass on its traditional seasonal trend, wherein the index begins to ramp higher during the final stretch of July.
While VIX has recently come closer than usual to forming something resembling a "trend" on the charts, with its steady downward trajectory of late, we often prefer to analyze the volatility measure in an inverse manner, by way of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) -- the price action in which is much more distinctly "equity-like" than VIX itself. XIV is based on the inverse of an index tracking short-term VIX futures, so this instrument will rise when VIX falls, and vice versa.
Given the action in VIX lately, it should come as no surprise that XIV has been flashing some of the signals that we would typically associate with overbought stocks. From July 17 through July 20, XIV notched four consecutive daily closes above its upper Bollinger Band. And as of the next session, on July 21, XIV entered "overbought" territory, as reflected by its 14-day Relative Strength Index (RSI) crossing above the 70 level.
While it's impossible to find any precedent for VIX's behavior this month, the same cannot be said of these developments in XIV. Schaeffer's Senior Quantitative Analyst Rocky White ran the numbers to see how VIX has reacted going forward following previous XIV streaks of at least three daily closes above its upper Bollinger Band, and the results suggest a volatility spike is almost inevitable after such a development.
Per the table below, the first such signal occurred in 2011, and there have been 10 in total since then. Looking out one week and two weeks after such a signal, the VIX has been higher 100% of the time -- including an average one-week return of 17.03%.
By comparison, the "anytime" VIX performance since 2011 looks quite tame. Over any given one-week or two-week time frame, the VIX is positive less than half the time, with average returns ranging between 1% and 1.5%.
But with five full trading days now in the books following this latest XIV Bollinger Band streak, VIX is up just 5.5% from its July 20 close (with the entirety of that advance collected in the final hours of Thursday's session) -- substantially undershooting the average and median returns following prior such signals. For what it's worth, the VIX returns following XIV RSI moves above 70 have been less eye-popping than the Bollinger Band signals, but still point to a distinctly stronger-than-usual positive VIX bias during the weeks following such an occurrence.
The graph below, meanwhile, charts the VIX course during previous years that have been similar to 2017 to date. While the "fear gauge" followed up a quiet start to 1998 with an explosion higher in the second half of the year, the paths charted by VIX in 1992 and 2004 suggest that a quiet VIX sometimes begets nothing more than an even quieter VIX -- which may be hard to fathom, given the index's current rock-bottom levels.
Perhaps one of the biggest "risks" to the low VIX right now emanates from the group of investors classified in the weekly Commitments of Traders (CoT) report as "large speculators." This group has been almost comically wrong when it comes to timing VIX futures, as our Senior V.P. of Research Todd Salamone has noted repeatedly in his Monday Morning Outlook column, and so the regular Friday updates on their current posture in this asset class have been a gift to contrarians. Large speculators continue to maintain a massive net short position on VIX futures, which means a volatility pop could easily be exacerbated by a large-scale unwinding among this contingent.
A counterpoint to this risk would be the steady dollar inflows into long volatility ETFs, which have not abated amid VIX's long march into record-low territory. The ProShares Ultra VIX Short-Term Futures ETF (UVXY), for one, has garnered more than $103 million in net inflows month-to-date, per etf.com data -- suggesting many traders are not yet convinced that their quest to profit from a "black swan" surge in volatility is once and for all a futile one, despite the billions that have been incinerated in such attempts in recent years.
And so from our perspective, as "rock bottom" as the "price" for long volatility positions may be (using such measures as the VIX), a strong case can be made that the requisite sentiment component for a tradable bottom (as in, capitulation by the volatility bulls) is still not yet in place.