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.

VIX Futures Weekly Wrap

It was a volatile week with a ridiculous Monday-Tuesday rally driving every point on the VIX futures curve one full standard deviation below historical averages before the big move up in the second half of the week.  Front month VIX futures (January) saw big gains this week as traders rolled over their protection with December options expiring (as predicted last week). 

VIX Futures Weekly Performance:

Jan-13	Feb-13	Mar-13	Apr-13	May-13	Jun-13	Jul-13
+6.1%	+1.6%	+1.3%	+0.5%	+0.2%	-0.5%	-0.2%

After seeing these numbers you might be surprised to learn that S&P 500 actually closed up 1.1% on the week.  At this point it seems that traders who wanted to buy protection have done so, making a short-term trade in shorting front month volatility (by buying XIV) somewhat attractive. However, due to the complete unpredictability of negotiations in Washington as we approach year end this still a bit like playing with fire. Might as well stay in cash and enjoy the holidays.

VIX term structure at the close of each day this week:

 

Market Complacency

While most people and the mainstream financial media often look at the spot VIX to gauge the level of fear in the market it really only tells a small part of the story.  The CBOE also provides values for VIX to track the expected volatility for each of the next nine months into the future.

An interesting point and indicator for market complacency is that the sixth month VIX future (May 2013) continues to float near its lowest point (20.5) since Oct 12, 2007 – the day after the S&P 500 hit its all-time high. This suggests that very few traders see a need for protection in the market at these levels, with an assumption that a market-positive fiscal cliff deal will get done, that the sovereign debt issues in Europe are under control, and the belief that the FOMC’s dovish policies will provide continued help for a domestic economic recovery.   While not a signal for a market sell off, it may serve as a good opportunity to pick up some protection in case the market turns down.