As VIX Hysteria Rises, One Signal That's Worthy of Attention

The following is a reprint of the market commentary from the June 2018 edition of The Option Advisor, published on May 25. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.

In the aftermath of the February 2018 volatility "melt-up" -- which proved to be an extinction-level event for some of the exchange-traded products (ETPs) tied to the Cboe Volatility Index (VIX) -- the narrative that has emerged in the financial media regarding the volatility complex has been borderline funereal in its tone. Trading in VIX instruments is now "scary," per a late-April Wall Street Journal article, amid thinning volume in the volatility index's futures and options. Meanwhile, analysts at J.P. Morgan recently downgraded Cboe Global Markets (CBOE) stock to "underweight," with the firm warning of "continued risk of a further slowdown in VIX futures activity... and... the potential for VIX options trading activity to slow."

Without a doubt, events like the late-February liquidation of the VelocityShares Daily Inverse VIX Short Term ETN (XIV), with its market value of roughly $2 billion, had a non-trivial impact on the number of VIX futures and options traded on a daily basis. But to put current VIX volume levels in their proper perspective, consider that 2017 was a record year for volatility futures, with 73.78 million contracts traded -- up sharply from about 50 million in 2014 and 2015, and roughly 60 million in 2016. And then consider that through the close on Monday, May 21, a total of 30.76 million VIX futures contracts had traded year-to-date -- up from 26.49 million over the same stretch of 2017 -- and it's hard to avoid the fact that VIX futures volume is still on pace to set another new record by year-end.

What's more, data this week from SentimenTrader shows a near-vertical ramp in the number of shares outstanding on a trio of major volatility-based ETPs -- the iPath S&P 500 VIX Short-Term Futures ETN (VXX), VelocityShares Daily 2X VIX Short-Term ETN (TVIX), and ProShares Ultra VIX Short-Term Futures ETF (UVXY). Shares outstanding on these three VIX vehicles have doubled since April, representing one sign of a healthy appetite among investors for volatility plays.

So with the storyline of "catastrophically cratering VIX volume" set aside for now, we'll turn to another notable development in the VIX complex of late -- namely, the return by large speculators to a net short position on VIX futures, as per the weekly Commitments of Traders (COT) report. This shift marked something of a "mean reversion," as these large speculators are, more often than not, net short VIX futures. But the group had adopted a rare net long position during the week ended Feb. 6 -- and ultimately maintained that stance for a staggering 14 consecutive weeks.

Regular followers of our stock market analysis may already be aware that we generally consider the COT "large speculators" data set to be a rather formidable contrarian indicator unto itself. Whether it's because they're hedging a boatload of smart-money plays or simply because they have incredibly bad timing, this group has regularly positioned itself on the wrong side of major VIX moves over the years. We become particularly wary about the equities market when the large speculators amass an extreme net short position on VIX futures -- just as they've done ahead of substantial volatility spikes in October 2011, May 2012, October 2013, and June 2016, to name a few examples.

Given that we've come to track this contingent's weekly maneuverings with greater-than-casual interest, it naturally piqued our attention when, as of the COT report for the week ended May 15, the large speculators had finally reverted to their "baseline" status on VIX futures -- a net short position, albeit an extremely small one, of 3,732 contracts. Since 2010 (the year VIX futures volume first began to take off in a meaningful way), there have been only seven other instances where COT large speculators have moved from net long to net short, and the returns following these rare occurrences are worthy of attention.

Data from Schaeffer's Quantitative Analyst Chris Prybal shows that in the immediate wake of these "COT mean reversions," the VIX tends to cool off, with the index logging larger-than-usual declines over the one-week and four-week periods following a signal -- although the two-week returns are largely in line with what's to be expected. After that short-term dip, however, the VIX then goes on to surge substantially over the next two-month, three-month, and six-month time frames, culminating in an average 26-week post-signal return of 38.76% -- easily dwarfing its comparable "anytime" return of 3.20%.

Note, too, that the percentage of positive returns for VIX is considerably higher than usual two to three months after a signal (rising as high as 86% at the 13-week mark). Once VIX reaches the one-year mark, however, the returns are once again 43% positive, and the average and median returns post-signal provide mixed messages.

As for the S&P 500 Index (SPX), it's just the opposite. After large speculators revert to net short VIX futures, the broad-based equity tracker comfortably outperforms its anytime returns over the next week, two weeks, and four weeks -- and then things break down. At the two-month mark, the SPX is positive only 29% of the time. Six months after a signal, the index's average return totals just 0.06%, compared to the anytime average of 5.90%. And, unlike the VIX 52-week returns post-signal, the S&P continues to display convincing underperformance as far out as the one-year mark.

In the simplest terms, it appears that stocks catch an initial tailwind as the large speculators unwind their net long positions on VIX futures. But looking at the VIX returns beyond those first four weeks, the group effectively proves its mettle as a contrarian indicator by returning to a net short position just ahead of massive VIX outperformance that takes place over the two-month to six-month markers.

Of course, the results above are not a "guarantee" of future performance following this latest shift in positioning by COT large speculators. Notably, after the group reverted from a net long to a net short stance on VIX futures in December 2011, the results going forward ran completely counter to the above -- the S&P matched or exceeded its usual returns over every time frame, while the VIX utterly tanked. The usual caveats aside, though, we'd argue this latest signal is one potentially troubling development in the VIX complex that's worth keeping on your radar as we head into the summer.