In the wake of February’s market volatility induced sell-off that resulted in the implosion of several volatility-based ETFs, I’ve written plenty on the topic. I’ve covered everything from what exactly happened, and the opportunities it presented to basic flaws in VIX related products, to the current SEC investigation as to whether there was market manipulation at work.
In the course of this coverage I tried to decipher what lessons might have been learned, how such an event might be avoided and what the overall future of VIX, and its home exchange the Chicago Board of Options Exchange (CBOE) might be.
I should have realized that just as market volatility itself is a mean reverting measure, so is the behavior towards trading it. Namely, the calls for the demise of both VIX related products and of shorting volatility have been greatly exaggerated.
After a brief dip in trading volume during March, trading in VIX futures and the related ETFs and options is back on pace for another record in 2018. This will be the fourth consecutive year of double-digit increase in volume.
Of more interest is that last week, the Commitment of Traders (COT) showed for the first time since February, large speculators are back to being net short on market volatility.
At first our response might justifiably be, “will they never learn?”
But as a recent report from Schaeffer Investment Research data shows that when COT reverts from net long to net short volatility tends to remain subdued and stock market tends to have a positive performance over the next 2, 3 and 6 month periods.
Here is the meat of the report:
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 spikes in market volatility 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%.
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.
