Market Trends Point To Another Year of Volatility in 2019

Navigating the stock market in 2017 was easy. Shorting volatility was easy money. Picking individual stocks was easy and everyone was a brilliant strategist.

Then came 2018. The graph below highlights the fact that while less than 2% of assets were negative in 2017, 90% of assets are negative YTD in 2018 -- they highest percentage since... ever.

In another stark contrast to 2017, the short volatility ETPs have lost over 90% of their value in 2018 thanks to February's historic volatility spike. Last year's buy-and-hold everything strategy has been a bust across the board in 2018.

One of the few assets that lost in 2017 was volatility. Unsurprisingly, volatility has been one of the few bright spots in 2018 with the VIX index gaining +74% YTD and VXX +32% YTD.

What sort of market trends appear to be happening now and on tap for 2019?
 - decelerating corporate earnings [now]
 - late stages of the corporate debt cycle [now]
 - decline of demand for U.S. Treasuries [now]
 - quantitative tightening [now]
 - slowing global growth [now]
 - trend of de-dollarization [now]
 - eventual reverse to more quantitative easing [late 2019]

That's a recipe for another difficult year for a range of assets with a strong possibility of wide movements within the equity markets as the year progresses. As we stated three years ago, traders need data-driven, reliable, observable, and easy-to-follow trading rules in order to set themselves up for consistent success. One of the reasons that 90% of people fail to make money at trading is they fail to have a process-oriented trading plan. As the saying goes, "Plan the trade. Trade the plan."

We think that volatility will again be a major factor within the markets in 2019. Our playbook to make money on short-term investing opportunities is to maintain a quantitative-driven investment process for volatility ETPs that has made us successful for the past 7+ years. Specifically, our VXX Bias and VRP indicators.

Why? Because they perform exceedingly well over the long term by trading both long volatility using VXX (soon to be replaced by VXXB) and short volatility using SVXY (previously using XIV).

We've previously noted that 2018 has given us trouble and that hasn't changed much since July. Our automated trading performance as tracked by a third party now stands at -22% for VRP+VXX Bias and +33% for VXX Bias. While the year is not yet over, those numbers are lagging average performance in most years. However, when the average annual return is north of 50% per year under a range of varying market conditions with best performance occurring during market drawdowns, it makes sense to stick with a good thing.

We take the guesswork out of the investing equation with a solid set of objective tools to guide decision making. At Trading Volatility our algorithms conduct daily monitoring of a variety of volatility-related data to generate our VXX Bias and VRP indicators which provide us with objective information about the likely direction of volatility ETPs, including VXX, VXXB, UVXY, TVIX, SVXY and ZIV.

Our algorithms continuously measure market data throughout each trading day and publish results on our subscribers' Intraday Indicator page. Our automation also emails and publishes the indicators' final values at the end of each day so that subscribers' can track the indicator of their choosing and act accordingly.

If you find yourself struggling in this market check us out. Stop guessing what will happen and sign up for our daily data-driven indicators for volatility ETPs.  To learn more visit our Strategy page and Subscribe page or drop us a line via the Contact page.

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Hypothetical and Simulated Performance Disclaimer
The results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Backtest results do not account for any costs associated with trade commissions or subscription costs.  Additional performance differences in backtests arise from the methodology of using the 4:00pm ET closing values for SVXY, VXX, VXXB, and ZIV as approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

Trading VIX Around the Upcoming Debt Ceiling Debate

With another debt ceiling debate looming just around the corner, many volatility traders ask "How do I play this event?"

Well to answer that question I like to first figure out where VIX is trading. Currently:

• VIX sits at 14.42 (currently +9.9% on the day)
• Actual volatility of the S&P 500 over the past  month (HV20) is at 11.50, 
• Actual volatility over the past 3 months (HV60) is 9.58. 

These values tell us that a VIX of 14.42 is actually high given the amount of volatility that the market is actually experiencing -- VIX is at a 25% premium to HV20 and a 50% premium to HV60. The market is already expecting a greater amount of volatility in the next month compared to what we have experienced in the past 3 months.

The recent rise in VIX to 17 in late August was for the most part attributed to the events in Syria. Once was a diplomatic solution was "found" VIX began to retreat to normal levels. As you can see by the green circles in the graph below, VIX tends to fall toward the "floor" set by HV60. With HV60 currently below 10 and VIX at 14.39 there is still a long ways to fall (33%). However, just because the floor is down below 10 doesn't mean that it'll necessarily make it down there.  HV20 is on the rise, moving from 6.49 in early August to above 11 today, an indication that the market as a whole is growing more volatile.

An interesting point in the chart above is 8/30/13 (see red rectangle) when the value of front month VIX futures (M1) was 17.5 and HV20 was 9.58, an 83% premium. It is rare for front month VIX to be above 17 while HV20 is below 10. In fact, in the past nine years this has only happened a handful of times (7/2004, 12/2009, 3/2010, 11-12/2010, 1/2011, 4/2011, 2/2012, 8/2012, 12/2012). In most instances M1 and HV20 converge towards each other over the next 3-6 weeks then rise rapidly together as VIX and actual volatility spike. We'll soon find out if the 8/30/2013 instance follows a similar pattern.

But given that VIX is trading at a premium to actual volatility and VIX futures are in contango, the expectation is that VIX and VIX futures will continue to fall. That means the "correct" long-term play as of now, due to the structure of VIX ETPs, is to continue to short volatility both for near-term VIX futures (long SVXY/XIV or short VXX/TVIX/UVXY) and medium-term VIX futures (ZIV), although I believe that smaller positions are warranted given the compression in the VIX futures curve.

Now that we've taken a look at the technical side, let's get back to the question about the debt ceiling.

We've been through several rounds of debt ceiling political theater weighing on the stock market. After a few rounds of debt ceiling and sequester deadlines in the past 2 years the market seems to be getting used to the sequence of events, complete with a last minute deal to once again kick the can into the future.

One idea of how to play the Sept/Oct 2013 episode is to wait for a VIX spike that occurs in the final hours of negotiation just before the deadline and short volatility. History gives us some positive data that this could be a good play. However, this strategy depends on several points:

1) Will market participants fret enough to cause a rise in VIX in advance of the event?

• In the July 2011 episode VIX ranged between 15 and 21. In Nov/Dec 2012 VIX ranged between 15 and 19.6. After hitting 12.52 last Friday, VIX is now at 14.32 with just one week left for congress to pass a "Continued Resolution" to continue spending after Sept 30th, and several weeks until all extraordinary measures to continue spending have been exhausted by the Treasury. Not only is the market not worried about this, but there's not even the infamous "countdown clocks" on the major media stations. I think you have to assume it will be political grandstanding business as usual and implied volatility will rise over the next several weeks, but it is not clear if this will happen as a gradual build up to the event, or more quickly just as the event is about to occur. Being long VXX over the next few weeks could be difficult given the "headwind" it faces due to the contango term structure. 

2) Will a deal get done?

• I think the answer is yes and I believe the market believes the answer is yes. Whenever this happens, the immediate reaction will most likely be positive and make for a very good short volatility play (assuming there is a build up in VIX leading up to it). 

3) Will a market-positive deal get done?

• Given the ratings downgrade and sell off after the July 2011 episode, this question should be of concern to investors as well. While a deal is likely to get done, investors will be looking at the "cost" of the deal. The details of  the deal, as well as the manner in which it is achieved, are just as important as the deal getting done in the first place. This will remain an unknown until it happens but is something to keep an eye on after the immediate reaction.

 
I prefer to take the information one day at a time to see how this episode plays out, closely watching for any significant changes to the VIX futures term structure and ensuring I have appropriate stops in place. The biases remain positive for SVXY, XIV and ZIV and negative for VXX, TVIX, and UVXY so I like to use those to my advantage while they exist.

Also remember that some periods of trading are easier than others. A directional move is easier to trade and more profitable than a choppy market, and you have to expect that the market over the coming weeks will be choppy and event-driven. There is a good case to be made to avoid this period altogether and wait for the "easy" money to be made once a new direction has been established.

Adverse Effects of ETPs Which Replicate Daily Returns of an Index

Happy New Year!

Before I get to VIX topics, today we kick off 2013 with passage of the "American Taxpayer Relief Act of 2012" which maintains the current income tax rate structure except for individuals making more than $400k/year. Somewhat counter to the name of the bill, everyone will see their taxes rise as payroll taxes increase revert back to 6.2% from 4.2% and additional taxes are withheld to fund the Affordable Care Act (AKA Obamacare).   You can read the entire text of the bill here.

All in all, the bill's provisions closed the U.S.'s $1,089 Billion annual deficit by $62B and taxes are still going up for all Americans. It increases the chances for a U.S. credit ratings downgrade in the next couple months and will create a slight drag on GDP for 2013.

While I was enjoying some vacation over the past couple of weeks the markets experienced a 27% round trip move in VIX, moving from 17.84 to 22.72 and back (now at 15.31 as I write this).  Volatility ETPs have been choppy since I made my exit from XIV on 12/11. Remember that these ETPs return the daily change of an underlying index. The adverse effects of ETPs which replicate daily performance returns of an index in a choppy market are apparent over this period:

• VXX (short-term VIX futures): -0.35%
• UVXY (2x short-term VIX futures): -8.3%.
• XIV (inverse short-term VIX futures):  -7.4% 

Conditions for trading VIX ETPs remain a bit rough at this time. Stay tuned for VIX trades as the day and year unfold.