(UVXY) Archives - Mad Hedge Fund Trader

There?s nothing like a swift kick in the shins, a slap in the face and a good boxing of the ears to give you a healthy dose of humility.

That?s how holders of the ProShares Ultra VIX Short-Term Futures ETF (UVXY) feel right about now. This is the popular ETF that rises when the S&P 500 (SPY) falls.

?Markets can remain irrational longer than you can remain liquid,? as my mentor, the legendary economist and early hedge fund trader, John Maynard Keynes, used to say. I know this because it is inscribed on a post it note taped to my screen.

This was only made possible by the Volatility Index falling to the $12 handle, the low for the year.

To see this happening with stocks at an all time high is nothing less than amazing. The (VIX) seems to be telling us that stocks are going sideways to up for the rest of the year.

I?ll believe it when I see it. Trees don?t grow to the sky.

The reason this fund can only fall over the long term is because of the contango that permanently haunts it. While the front month Volatility Index (VIX) is trading at $13.92 today, three-month volatility is at a lofty $20.

The (UVXY) buys three month volatility and runs it into expiration. It then exacerbates this negative impact with 2X leverage. The guaranteed loss on this trade is therefore $3.37 X 2, or 43.5%. It is a perfect money destruction machine.

Do this every month, and eventually you use up all your capital. You see this most clearly on the long-term split adjusted (UVXY) chart below, which has it going from $30,000 to $42.33 in only three years, a loss of 99.9%.

This is why you should only hold the position for a few days or weeks at the most, and even then to hedge long positions in other stock or indexes.

You only want to own (UVXY) and the (VIUX) during the brief, frenzied volatility spikes that occur, as we did with the last trade.

You might want to ask the question, ?Why aren?t we shorting this thing??

The (VIX) is prone to sudden, extreme moves to the upside whenever an unforeseen geopolitical or economic event takes place, such as a terrorist attack or a bad monthly nonfarm payroll number.

It can double in days, as traditional long side investors who are unable to sell short stocks or futures rush to buy some downside protection. It has done this a few times in the past year. During the crash, the (VIX) ratcheted all the way up to $90.

Often you get large moves of 20% or more right at the opening, as professional traders, who are almost always short volatility, rush to cover short positions, all at the same time. As a result, many of the people who try this strategy often go bust.

On top of this, your broker is unlikely to extend the margin you need to put on a decent position, especially to beginners.

The concern is that when the customer wipes himself out, they will take a piece of the broker?s capital with it. Customers who lose money in this way often end up suing their broker, another turn off.

The people who do make money at this tend to be large teams of very experienced traders with massive computer and programming support executing complex, state of the art risk control algorithms.

It costs millions of dollars to put all this together.

Needless to say, you should not try this at home.

Maybe the market is trying to tell me something. Like, quit looking for a seat after the music stops playing. Don?t trade if there is nothing there.

This is why I have backed off to a very rare 90% cash position, which I hate. Nobody pays you to hold cash.

It looks like it is going to be a long summer.

I am one of those cheapskates who buys Christmas ornaments by the bucket load from Costco in January for ten cents on the dollar because my eleven month return on capital comes close to 1,000%.

I also like buying flood insurance in the middle of the summer when the forecast here in California is for endless days of sunshine.

That is what we are facing now with the volatility index (VIX) where premiums have been hugging the 12%-14%% range recently. Get this one right, and the profits you can realize are spectacular.

The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index, which has been melting since the ?RISK OFF? died a horrible death.

You may know of this from the talking heads, beginners, and newbies who call this the ?Fear Index?. Long-term followers of my Trade Alert Service profited handsomely after I urged them to sell short this index at the heady altitude of 47.

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.

The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?

For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don?t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.

The (VIX) is expressed in terms of the annualized movement in the S&P 500, which today is at 1,800. So a (VIX) of $14 means that the market expects the index to move 4.0%, or 72 S&P 500 points, over the next 30 days. You get this by calculating $14/3.46 = 4.0%, where the square root of 12 months is 3.46.

The volatility index doesn?t really care which way the stock index moves. If the S&P 500 moves more than the projected 4.0%, you make a profit on your long (VIX) positions.

Probability statistics suggest that there is a 68% chance (one standard deviation) that the next monthly market move will stay within the 4.0% range. I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.

It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the ?hedge? in hedge fund.

But wait, there?s more. Now, erase the blackboard and start all over. Why should you care? If you buy the (VIX) here at $14, you are picking up a derivative at a nice oversold level. Only prolonged, ?buy and hold? bull markets see volatility stay under $14 for any appreciable amount of time.

If you are a trader you can buy the (VIX) somewhere under $14 and expect an easy double sometime in the coming months. If we get another 10% correction somewhere along that way, that would do it.

If you are a long-term investor, pick up some (VIX) for downside protection of your long-term core holdings. A bet that euphoria doesn?t go on forever and that someday something bad will happen somewhere in the world seems like a good idea here.

If you don?t want to buy the (VIX) futures or options outright, then you can always buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Easier still is the (UVXY), which is particularly useful for trading narrow ranges like the one we have had.

If you lose money on this trade, it will only be because you have made a fortune on everything else you made. No one who buys fire insurance ever complains when their house doesn?t burn down.

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