What message does the positioning in the VIX futures market hold for you? An average correction in the stock market can become a sharp decline if volatility jumps.
After the huge spike in volatility as the financial crisis erupted in 2008-2009, the level of volatility has trended lower once the European sovereign debt crisis calmed after 2011. The level of volatility in the stock market is measured by the Volatility Index (VIX). Development of investment products based on the VIX created the opportunity for hedge funds and investors in general to incorporate investment strategies using VIX ETFs. In recent years, one of the most profitable trades involved shorting the VIX, which amounted to a bet that volatility would continue to trend lower. This trade proved very profitable and attracted more money as volatility did indeed trend lower from 2012 through 2017. The downtrend in volatility was interrupted by a brief upward blip after China devalued its currency in August 2015 and oil prices collapsed in early 2016.
If you’re not aware of the how hedge funds are positioned in the VIX futures you can get blinded as many investors were last year in February and again during the stock market swoon in the fourth quarter. The popularity and size of the positioning in the VIX is illustrated by the number of long or short contracts in the VIX futures market as a percent of open interest. As you can see, as volatility declined after the uptick in volatility ended in early 2016, the short position in the VIX was sustained at a high level (below -30%). When volatility increased in February 2018, the VIX spiked higher and those short were forced to buy in order to cover their short position. That buying pushed the VIX higher forcing even more shorts to cover. Within 7 trading days the VIX rocketed from 11.06 on January 26 to 50.30 on February 6! The spike in volatility contributed to the sharp -9.7% decline in the S&P 500.
Were you surprised by the big decline in the stock market the fourth quarter?
After the market calmed down and the S&P 500 rallied to a new high in September 2018, the short position in the VIX futures was slightly larger as a percent of open interest than in January 2018. Here’s a quote from my October 1, 2018 Weekly Technical Review.” The percent of bulls in the Investors Intelligence survey last week rose to 60.6% an unusually high level. This indicates that bullish sentiment is high even though the internal health of the market has been weakening for weeks. Should a decent reason to sell materialize, a quick sharp decline is possible, especially since there is a large short position in the VIX.” When concerns about the Federal Reserve’s monetary policy and the slowdown in global growth led to a wave of selling, the S&P 500 dropped by 20% in 3 months and the VIX jumped from 11.10 on September 21 to 36.10 on December 24.
What message does the positioning in the VIX futures market hold for you now?
The net speculative short position in the VIX reached the highest level in history at the end of March 2019. This suggests the tinder for the next sharp increase in volatility in the stock market is already in place just waiting for a spark to ignite it. You may not have to wait long.
The S&P 500 has rallied strongly after bottoming in late December. The VIX has consistently fallen to a lower low as the S&P 500 achieved a higher high. That changed as the S&P 500 marched to another new high (green line) on April 3, but the VIX made a higher low (red line) for the first time since December. This is a hint that the risk of an increase in Volatility is lurking right around the corner.
In the April 1 Weekly Technical Review I discussed how the improvement in China’s PMI index could impact the global economy, U.S. monetary policy, and provide a shock to the bond and stock market before the end of 2019. Although the S&P 500 is making new recovery highs, you need to know how the overall market is doing. What you don’t know can and often will hurt you!
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