As you can see in the following chart, the ProShares Ultra VIX Short-Term Futures ETF (UVXY) has continued downwards during the month with shares erasing most of the gains seen earlier this summer.
At present, I have two different views on UVXY. In the short term, I believe that we’re likely going to see some upside in the instrument in line with seasonal tendencies in the VIX. In the long term, however, I believe that we are almost certainly going to see UVXY head lower.
To kick this piece off, let’s take a broad thematic look at the current VIX levels.
The VIX is sitting around 27 at the time of writing. Over the past month, we have seen a fair degree of volatility in the VIX with the index hitting as high as 38 early September after touching numbers in the low 20s a few days prior.
Historically speaking, the current VIX level is actually suggestive of short-term declines going forward.
As you can see in the above chart, when the VIX is around the same level that it’s sitting at today, the odds of it rising over the next month are only about 27%. In other words, over the last 27 years, the VIX fell 73% of all times that it was sitting at levels similar to what we’re seeing today.
An important thing to note about this study is that it is very broad – that is, it takes the simple level of the VIX and uses it predictively. In my opinion, this type of study works most of the time (as clearly seen in the statistics); however, it must be framed up by current developments in the markets. Let’s take a short-term look at the S&P 500 to try and gauge where it may be headed over the next few trading sessions.
At present, the S&P 500 has broken out of its short-term trend to the downside as of today. Prior to this movement, the market was caught in a relatively tight channel trending downwards following the peak in the market in early September. Late last week, the S&P 500 found support at the zone of prior resistance established in June which has lent support to the current rally.
I believe that in the short term, we are likely going to see the S&P 500 make another attempt at the lows in this trend. I base this on the fact that momentum remains negative as seen by the MACD chart below. As long as momentum remains negative, I am treating each rally with suspicion and viewing it as a good shorting opportunity until momentum shifts in the other direction.
From a more qualitative standpoint, I believe the market is also subject to selloffs on the basis of the spreading virus. While I believe the shock and fear factor has largely been removed from most news updates regarding the virus, the market has demonstrated a high degree of responsiveness to news regarding the disease throughout this year. Until we see a marked change in market-driving catalysts, I believe any changes – either positive or negative – to the virus situation will result in market-driving action. And given that the recent news is bad with 21 states reporting an increase in cases, I am on the lookout for additional selloffs in the market.
For VIX traders, the reason why it’s critical to get a view on the S&P 500 is that VIX and the market are highly correlated. If the market falls, VIX will rise.
This chart shows a very clear relationship between changes in the market and changes in VIX. To put this into today’s market terms – if we see the S&P 500 push into new lows in its immediate trend over the next month, then we could see VIX rally by 20-30% based on historical correlations between market movements and VIX movements. UVXY doesn’t precisely track the VIX, but one more downswing in the market could result in this ETF rallying by upwards of 45% (depending of course on the speed of the selloff).
In the short term, I’m actually moderately bullish on the VIX – despite the fact that the VIX is already somewhat elevated. I believe that the technical and short-term fundamental picture suggests that the VIX is headed higher (potentially in the territory of 20-30% over the next 1-2 months). This said, I believe we also have the clear seasonal tendencies supportive of a long VIX position during this time of the year.
Historically speaking, the average level of the VIX tends to rise starting in August and through November. This means that over the next 2 months, we are in a statistically-favorable environment supporting rallies in the VIX. Seen from another perspective, the average volatility of the VIX tends to peak in the late October/early November timeframe.
Not only is this the case but election years tend to see rises in the VIX with markets normally seeing an expansion of volatility through the end of the year.
All this said, I believe the short-term numbers have an unusual degree of risk associated with shorting the VIX and that for the next 2 months, investors should look to the bullish side. However, in the long term, I believe the numbers are overwhelmingly clear that UVXY is headed lower and the most reliability profits can be found by long-dated shorts in the instrument.
A central message that I try to convey when I write about UVXY is this: it is not the same thing as an investment in the VIX. This is a very important thing to note because of the simple fact that the longer you hold UVXY, the less your investment will be correlated with the VIX itself.
What this chart shows is the correlation between the S&P 500 VIX Short-Term Futures Index (the index UVXY leverages on a 1.5x basis) and the VIX itself over a certain holding window. This shows a very clear relationship in that the longer that you track this index, the less the correlation your holdings will exhibit with the actual VIX.
This means that holding period of your investments is critical: if you’re a short-term trader, then you need to pay a higher degree of attention to what is driving the VIX. If you’re a long-term trader, you need to study this index and methodology in depth to understand what is driving this long-term performance. In others, your holding period dictates which type of strategies you should be trading.
I believe that the long-term short UVXY trade is a clear winning trade. The reason why I say this is manifold. First off, UVXY’s methodology has resulted in unleveraged losses at a pace of over 47% per year for the past decade. These long-run returns are so brutal that if you’ve held UVXY for longer than a few years, you’re staring at virtually 100% losses.
And the second reason why I believe that the long-term short remains a winning play is the underperformance exhibited between UVXY’s index and the VIX through time.
This chart shows a very clear trend between holding period and underperformance of UVXY’s index. The longer that you hold UVXY’s index, the greater you will underperform the VIX. And when you consider that the VIX’s distribution has it mostly in a fairly tight range, this means that long-run losses are to be expected.
Put simply, the data is clearly showing that a long-term short on this index wins. But why is this? I believe that before we can arrive at a recommendation, we need to examine what is actually driving this. This key driver is called “roll yield.”
The key problem with UVXY is that it’s trading VIX futures. And these futures are largely in contango (that is, priced above the spot level of the VIX). The problem with contango is that as time progresses, contango narrows until the spot market and the front month VIX futures contract trade at parity around expiry.
This is the problem with a long-term holding in UVXY. Its methodology has it start a month with 100% of its exposure in the first month and end the month with 100% of the second month (at which point the second month becomes the front month contract and the process repeats).
Since VIX futures are largely in contango (in around 85% of all trading days over the past decade), most of the time UVXY is holding futures which are priced above spot. Since these futures are converging towards spot, they are declining in value in relation to the spot. This results in losses for UVXY holders as these futures decline towards spot. This consistent relationship has driven year upon year of losses for UVXY holders.
I believe this is the key winning trade for UVXY: buy long-dated puts to capture this relationship. This is how I am trading UVXY and at present, I own put options all the way out to 2022. History shows that futures are priced above spot and they converge. Given the degree of this convergence, long-run returns of UVXY are strongly negative.
In the short term, the VIX is likely going to rally as the market tests the current lows in its trend and seasonality influences volatility. In the long run, UVXY is likely headed lower as key roll-yield tendencies exert themselves on the futures held by the ETF. Given the strongly-negative long-run returns, long-dated puts on UVXY are likely the best trade at this time.
Disclosure: I am/we are short UVXY. 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.