VIX set to Spike

VIX to Increase Short Term

For those that don’t know, the VIX represents the implied volatility expected to be realised in the S&P 500 over the next 30 days, and is also known as the ‘fear index’. For those that already know this, you’ve probably had a few fearful days trading the spikes recently, as the mini contracts as about as small as Jeremy Lin.

Traditionally, volatility rises when markets are falling and falls when markets are rising. A 10 day moving average of the correlation between the VIX and S&P highlights this inverse relationship, as shown below:

The spikes, where correlation moves towards 0, indicate that either markets are rising quickly or stocks are grinding slowly lower, but back-testing indicates that this doesn’t mean the opposite (large falls or small gains, favouring a short position in the S&P) trend is imminent. It is profitable to be short the VIX when the correlation spikes, suggesting the relationship primarily breaks down when stocks fall too slowly, but the annualised rate of return is less than 5% over the past few years.

The Trade

The trade that is suggested is to be long the VIX index at any levels below 20, with the view to exit at 25, or higher if it has strong momentum. Given the complexity and volume of unresolved issues in Europe and the high level of most US economic surprise indicators (data consistently surprising to the upside), there are plenty of short to medium term catalysts for a spike in the VIX, and little just cause for levels below 15 to be realised. It only takes a couple of data releases to conflict with the currently positive thematic, a Eurozone Grexit or a credit downgrade of France or the UK to inject some more uncertainty, and that’s all that’s required for this trade to be profitable. Volatility between 15 and 20 is sustainable but unlikely to hold perfectly in these macro conditions, and a move below 15 would be seen as improbable and short term.

Conflicting comments such as Buffet describing bonds as ‘dangerous’ and Pimco’s increasing of their allocation to Treasuries from 30% to 38% over the last quarter will do little to assure the market than the worst is unquestionably behind them with no bumps ahead. Markets may be grinding higher, but the number of reputable and differing views isn’t unlike one of those group projects at university. Get a task, split it up, everyone does it differently, you all split it up again, it comes back differently etc. One by one we all completed it the same way, as the answers became clearer, but not without a few bumps along the way. The VIX is no different. It can’t get anywhere without a few hiccups and spikes, and the global macro environment looks like it could justify a spike sooner rather than later.

To finish on a lighter, though arguably similar fear inducing note, here’s an eerily true ‘joke’ I came across:

“A student asked a professor of economics: ‘what is the difference between socialism and capitalism ?’ The professor answered: ‘capitalism is the exploitation of humans by humans’. The student then asked, ‘and socialism?’ The professor replied ‘the inverse of course’.”

In the pipeline: Is uranium ready to return?

Bullish on: Gold miners (global gold miners, in particularly NCM.AX failing to price in spot gold). 

Bearish on: US 10yr Treasury Notes (yields too low considering equity market performance), TLS.AX (defensive stocks to lag, reaching broker targets around $3.40).

As always please leave any comments or feedback that you may have, and if you’re looking for a beginner’s trading guide consider reading some of the articles at www.tradingpimm.blogspot.com.