XIV is About to Get Dangerous

September 29, 2015

For a long time I have been an advocate of the long XIV trade, or effectively, to short any volatility spikes. This strategy has worked very well during the most recent bull market. Who wouldn't be lured by the tenfold gain seen on the XIV chart?

XIV nicely weathered every dip since 2011. Source: ThinkOrSwim

As always, past performance is not predictive of future returns. XIV has been smashed by this recent rout in the market, having fallen over 50% from its all time high. In fact, the XIV trade does not seem to be working well in general lately. It's price has had some wild swings since the fourth quarter of 2014.

What Happened to Contango?

As I explained in a post last year, XIV's returns have been supercharged by a prolonged period of backwardation on the CBOE VIX futures curve. Then early this year I wrote a follow up to that post when I noticed that XIV seemed to have broken its long term trend. I put forth several reasons that we may be entering a new phase of volatility where the persistence of contango helping the XIV may no longer be so reliable.

Since the stock market began its correction at the end of August, XIV has been hurting because the futures curve is stuck in backwardation. Unlike most volatility spikes in recent years, this time the VIX and backwardation are not fading so quickly. To better understand how this could impact XIV, I conducted a study of past "sticky" volatility spikes to determine if we could gain insight into the near future.

In this study, I make the assumption that any VIX spike above its long term average will send the VIX futures curve into backwardation. This will happen because the price of the nearest expiring futures contract is drawn to the spot price of the VIX, but longer dated futures contracts are drawn to the VIX long term average. The difference between the current VIX futures contract and the spot is what traders call the roll yield. This blog article by VIX Contango Oscillator explains it very well:

...a VIX Future contract over the long term tries to reach the average spot VIX value. The farther out in time the future, the closer the fair value will be to the average historical VIX value. The delta between the future price approximation and the average value goes exponentially closer to zero. The flipside of that calculation is that the nearest term VIX future has the largest difference to the long-term average, the second term VIX Future - the second largest difference, the third term VIX Future - the third largest difference, etc. The exponential decline in the delta can be plainly seen in the usual VIX Future Curve formation depicted above (Contango formation).

I downloaded the historical spot VIX prices from the CBOE website.  Using data from 2004-2015, I calculated the average value based upon the daily closes to be 19.4. Next, I wanted to determine how often and the length of intervals that the VIX spends above its long term average.

My theory is that when the VIX is above the long term average, the short term VIX futures is more likely to be in a state of backwardation. Backwardation is harmful to XIV. Therefore, prolonged periods of time when the VIX remains above 19.4 should be very detrimental to the price of XIV.

Study Findings

From 2004-2015, I learned that the VIX spent roughly 1/3 of its time above the long term average. The median of 16.4 indicates that the distribution of where the VIX spends its time is skewed upward. In other words, a fewer number of high VIX days during spikes has pulled the average higher.  This would explain how the VIX futures could spend more days in contango than backwardation.

Source: Derived from CBOE Figures

The longevity and distribution of VIX spikes is most interesting. I noted the length of periods when the VIX went above its long term average and held for a number of days. As expected, tumultuous times in the market correlated to longer periods of an elevated VIX. Here are key periods of time when the VIX went above its long term average of 19.4 and held. (I only analyzed whether the VIX was above or below 19.4; point value of much was not examined.)

I then grouped each period of high volatility into year and quarter.

Percentage of days within each quarter where the VIX was above its long term average of 19.4

This table shows that the VIX is polarizing! During tumultuous times the VIX could remain elevated for extensive periods, which is very bad for XIV. In 2009, the VIX stayed above its long term average for the entire year. But during periods when the markets are relatively calm such as 2004-2006, the VIX won't spend more than a few days at a time above its long term average.

XIV was launched just before a period of historically low volatility. This has given the dangerous illusion that XIV is invulnerable and will always be driven higher by contango, which is not always the case. The only time we've really gotten a taste of how prolonged volatility affects XIV is 2011 when it took a 75% drawdown during the debt ceiling crisis.

Teal shaded periods denote VIX > 19.4. Source: ThinkOrSwim

It is possible to use the SPVXSP index to backtrack the theoretical performance of the XIV before it was created, as described on this other blog. If only more traders had this view of the XIV during the 2008 financial crisis, perhaps it would be less appealing. As the author states, if you model the performance of XIV back to 2006, you will see that it would have lost 80% of its value at some point.

Source: onlyvix.blogspot.com


Where can XIV go from here?

I use a proprietary model to estimate potential future prices for XIV based on percentage changes in the underlying VIX futures prices (months 1 and 2). As of today, my model indicates that the current effective price for the XIV's underlying VIX futures is 23.63. If in one day the VIX futures months 1 and 2 mix were to move to an average of 30, we could see XIV dip into the upper teens. The good news is that if volatility were to somehow go away and drop back to ~14, we could see XIV rally into the upper 30s.

However, as we can see from the charts above, "sticky" backwardation can happen when the VIX finds support above its long term average, causing XIV to get hammered. I see this scenario as likely until near end of the year at best.

How I'm Trading This

The quickness and severity of the current VIX spike caught me by surprise. I was sitting on a small position from the upper 40's. When it gapped down and settled into the 20s I began building a more serious position. My plan was to add the rest of my intended shares upon any sign that the VIX was receding as usual, but that didn't happen yet. In fact, I made a mistake by buying into the fakeout rally following the most recent FOMC meeting, hurting my average.

My research now tells me that since we are nearing 30 days with the VIX holding steady in the 20s, we may be in for a much longer volatility ride. This will not bode well for XIV. Until the S&P 500 reclaims the 2000 level, the VIX retreats back into the teens, and/or the VIX fades below the 200DMA, I do not think XIV is going to generate stellar positive returns. Judging by the length of past market corrections, I would venture to guess that the VIX can remain elevated for another quarter or more. Therefore, I will be reducing my size into rallies and looking to buy back at a better cost average.

One of my personal weaknesses as a trader is that I am often too early in acting on an idea. Executing too early will get you a bad entry. With my buying power tied up through premature trades, I will not be able to buy more shares unless I unload some. I certainly don't want to be heavy handed in XIV if the S&P500 falls to its next level of support at 1810.

Final Word

XIV inverse volatility is a compelling instrument. It's extreme performance over the last several years has caught the attention of many traders. However, the recent changes in the patterns of the VIX lead me to believe we are entering a new period of increased volatility, which would be harmful to XIV as a long term holding. Use caution when building a position as long as the VIX is supported above its long term average of ~20.


Are Chinese tech stocks ready to turn?

April 8, 2015

This morning there was a lot of activity in the beaten down Chinese stock sector. I think this could be the start of a much bigger move. We are early in the second quarter and the activity I see this morning could be the start of a rotation of institutional money into Chinese stocks.

Steve Spencer of SMB Capital recently did a video on their blog about how to trade the bottom in a correction. He does an in depth review of how he spotted and successfully traded last year's correction in small cap tech stocks. I think this year we've seen a similar correction in Chinese stocks and it may be bottoming out.

One of the signs Steve looks for to identify a correction is a basket of stocks. In a correction, he expects the leaders to be down 20%, and in some cases as high as 40% pullback from the highs. If you look at the recent performance of some of the high flying Chinese tech stocks from last year, you will certainly see this is the case:

Some of the stocks like JD, CTRP, and ATHM were actually down much more but have recently started climbing back to the highs. We may soon see other former leaders in the group like WB, DANG, and QIHU catch up.

In Steve's video, he says that he also likes to look for a clear level of support that holds as a bottom. The bottom is especially strong if it holds through an earnings report, or if some volume selling comes in but is unsuccessful in crushing it to new lows that stick. I think we are seeing such a consolidation in many of these. Here are some of my favorite charts right now.

BABA - 80 seems to be a floor.

KNDI - 10 has been a solid support going back to the very beginning of 2014. There seems to be some recent support at 12 on the shorter time frames. A move to the 200DMA near 15 seems well within reach.

WB - This thing is beat, but its got a nice series of higher lows since it got near 12 at the beginning of February. With only a 13M share float, it could take off substantially if money flows in.

Trading Plan

I'm going to have a close eye on these stocks over the next few days. Some of these I've started into today with small positions. For the most part I'm going to be waiting for dips and picking to go long on key short term technical levels where the tape holds.

How to Trade Breakout Remount Setups

March 30, 2015

This is part two of a series of trade setups I'm examining in greater detail. In the last piece, I focused on the breakaway gap setup. In this blog article, we will examine a closely related trade setup called a "remount". A remount happens when a stock price breaks out of consolidation to a new trading range but initially fails, pulling back to make a higher low before following through with the real breakout.

Here is a recent example. LQ came out with a positive earnings report and looked like it was going to break out through all time highs. However, it hit resistance at 23 and sharply pulled back. It consolidated in the mid 22's for several days before resuming its breakout, clearing the 24's.

Gap Up Remount vs. Retest of the Breakout Area

In my writings, I am going to break down remount setups into two categories. The first category happens in conjunction with some news such as an earnings release. The stock gaps up during the premarket, possibly opening higher than the previous day's high. It looks like a potential breakaway gap setup but then fails and has to remount before moving higher. I call this scenario the gap up remount because a gap up is involved, which means it usually follows a failed breakaway gap setup. The area of support that it finds is usually near the price it gapped up from or a new level of resistance/support created on the first day.


Note that not every gap up remount necessarily stems from a failed breakaway gap up. In many cases such as KR you can have a successful run in the gap, but then several days later profit taking brings it back to a support area from days prior in which you can go long. KR initially had a nice breakaway gap from 73 to the upper 70's in which you could have taken profits if you went long on day 1. The remount gives you a second opportunity.

The second variation I call a breakout remount or breakout retest. This happens in the absence of big news or significant premarket gap. It's just a stock that's been sitting flat for a while that starts to make a move out of an area of consolidation. Such moves usually zig zag higher, coming back to the previous area of resistance or just below it on day 2 or 3 of the run.

The main difference between the gap up remount and the breakout retest is that one is news driven while the other is not. The breakout retest setup may also be a characteristic of other setups such as a bull triangle. The longer the stock consolidates in a range prior to the breakout, the more powerful the breakout usually is.

Time Frame & Patience

With the breakway gap setup, you can often take substantial profits on the first day. Remounts move more slowly. It takes time for the price to find support and therefore I recommend spotting this setup only on the 5min, 15min, or 1hr charts.

Some remounts happen quickly (in a relative sense), bouncing back to the ATH after only several days. Others may linger and the previous area of support for several weeks before making the up move. This kind of setup moves slowly - it's pretty much a swing trade only. However, it seems to be fairly reliable with a very good risk/reward if you are patient enough to avoid the mistake of taking profits too early.

Changes to My Posting of Ideas

I've been trying to get more methodical with the way I use Stocktwits and post to this blog. If you noticed, I've been using hashtags lately to denote the setup I see. This past several weeks I've also taken a hiatus from posting watchlists as I've only been focusing on the breakaway gap setups which I scan for primarily in the premarket of the trading day. I'll be back to regular posting of watchlists soon with better explanations around the setups I'm looking to play.