The Volatility Death Spiral Continues

Mr. Market sometimes speaks in mysterious tongues, and you really have to wonder what he is struggling to tell us by taking the Volatility Index (VIX) down to a subterranean $13 handle on Friday, a new five year low.

A number of advisors have been recommending that investors load up on the (VIX) in recent months to give them downside protection from an imminent market crash. Those who followed such advice were hammered, their clients no doubt striking them off invitation lists for summer barbeques.

In the past month, the (VIX) has cratered from $20 to $13. Just last October, it touched $49, when I urged readers to pile in on the short side. I came out in the mid-$30?s weeks later.

Those who traded the triple leveraged (TVIX) fared even worse, this blighted ETF plunging from $5 to $2.50 during the same period. The (TVIX) is doing the best impression of an ETF going to zero that I know of. A year ago it was trading at $110. This is why I plead with traders to avoid triple leveraged ETF?s like the plague. These things are designed for day trading by hedge funds only. Eventually, they all go to zero.

I am even seeing this in my own portfolio. A week ago, I sold short the September, 2012 (SPY) $147 calls at $0.38. A week later, the (SPY) has risen by 1.2% but the call options have done a swan dive to $0.34. This can only happen when they are crushing volatility.

I quit recommending (VIX) plays in March when I realized that there is some sort of arbitrage going on in the hedge fund community that is punishing (VIX) owners. I haven?t figured out the exact mathematical dynamics yet, but it has to involve selling short the cash stocks and shorting (VIX) contracts against them. Whatever they lose on the cash short is more than made up by the profits on their (VIX) short.

It?s easy to see how successful this would be. While August (VIX) traded at a lowly 13.40%, September volatility is still up at 18%, and January, 2013 is trading at a positively nosebleed 25%. That spread provides a lot of room to take in some serious money.

So what is the 13% really trying to tell us? Here are some thoughts:

*It is discounting multiple tranches of quantitative easing by central banks around the world that take all asset prices up for the rest of the year.

*It reflects the complete abandonment of the stock market by the individual investor, which is why trading volume has collapsed.

*It also indicates how exchange traded funds are taking over, sucking volume out of the stock market. The (VIX) doesn?t reflect activity in ETF?s.

*It could be discounting an Obama win in the presidential election. Stocks have delivered a 72% return since the Obama inauguration, the third best in history after Franklin Roosevelt and Bill Clinton. Mixed stock and bond portfolios have delivered the best returns on record, with both asset classes appreciating dramatically for 3 ? years, something that never happens.

It could be that the (VIX) at this level has it all wrong, and that a stock market selloff is about to send it soaring. Those who have rigidly held on to that belief until now have been severely tested.

For those who have fortunately avoided the (VIX) trade so far, let me give you a quick primer. The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index. You may know of this from the talking heads on TV, beginners, and newbies who call this the ?Fear Index?.

For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations.






Ready to Take the Plunge on Volatility?

The Final Word on the Volatility Index

The inside story on the collapse of volatility is now out, and as a result, managers are reviewing the harsh lessons learned and tweaking their strategies. It highlights the dangers of buying securities without reading the prospectus and understanding what is under the hood.

As investors piled into stocks in February, they also bought downside protection in the form of the Velocity Shares Daily 2X VIX Short Term ETN (TVIX). For reasons that are yet to be explained, the issuer, Credit Suisse, arbitrarily decided to quit issuing new shares, effectively turning this vehicle into a closed end fund. Money poured in anyway, driving the price up to a 100% premium over the intrinsic value of the fund.

Then, out of the blue, Credit Suisse reversed its decision and decided to issue new shares after all last week. This could mean only one thing to the professional volatility trading community, which jumped on the (TVIX) with both feet. They took the ETF down a stunning 65% in a week, all the way down to a 20% discount to intrinsic value. During the same time, the (VXX) fell by 25%, while the (VIX) was up 10%. Now that?s a tracking error with a turbocharger!

It now appears that there was some advanced knowledge about the reissuance of shares, and the SEC is almost certain to make inquiries. Those who had hoped for downside protection in the stock market got a slap in the face instead. To say the least, confidence in the financial system has not been advanced.

To make matters worse, a major hedge fund based in Chicago has a gigantic position in the (TVIX) with a ?put tree?. This involved buying one $21 put and selling short one $18 put and three $17 puts. Below $17 they were 300% long the (TVIX). When the ETF broke that level, the sushi hit the fan, triggering panic selling of all (VIX) products at any price, including the unrelated (VXX). I can?t tell you who it is without risking litigation. But with the quarter end upon us, their investors will find out soon enough. Watch the newspapers to find out whom.

The debacle has sent analysts scurrying to find other ETF?s that may be trading at premiums to their underlying. Here are the top three:

Platinum (PGM) 27%
Municipal bonds (GMMG) 14%
China small cap (PEK) 6%

The premium in the (UNG) frequently goes as high as 50% and results from the contango in the futures market, where far month contracts are trading at big premiums to the front month. That makes it a great shorting vehicle in falling markets, because the ETF always falls faster than the underlying. I have drunk at this well many times.

What happens from here? My guess is now that managers see that their downside protection is a sham, they won?t want to play. That could translate into stock selling, now that holders understand that these positions involved more risk than they realized.

In the meantime, if you plan on dabbling in the $1.4 trillion 1,400 issue ETF market, it may prove wise to check out the intrinsic value of any ETF before you buy it. You can do this easily by going to Yahoo Finance and adding .iv to any ticker symbol. So while the (TVIX) intrinsic value this second is at $7.51, the current market is at $7.96, a 6% premium. If you value your wealth, you might well get familiar with this exercise.





Trading Volatility Isn?t Always So Fun

Volatility Melt Down Continues

The market was buzzing today about the continued collapse of volatility and the significance thereof today. Today the chief whipping boy was the double leveraged Velocity Shares 2X Vix ETF (TVIX), which cratered 33% on the day, and down 90% from its October high.

This was on a day when the ETF should have gone through the roof, with the Dow down 100 points and a rapidly deteriorating Chinese Purchasing Managers Index threatening of worse to come. Even the (VIX) and the (VXX) only brought in modest gains at best. Against this backdrop they should have been up much more.

Conspiracy theories abounded. Some speculated about margin calls on a major hedge fund triggering a forced liquidation. Other?s thought that complacency was peaking, creating spike bottoms in volatility products that could signify a final move. Certainly a buying opportunity is setting up here, but how do you determine where when the ETF is doing the exact opposite of what it is supposed to do.

Whatever the reason, investors? trust in these instrument has been permanently dented. A 33% one day drop certainly was not in the prospectus.