Calm Waters---And Then Comes The Hurricane

By John Gilluly reposted from Seeking Alpha

The VIX Volatility Index is currently at a 7 year low.

There have been 10 volatility events (spikes up or down) in the last 18 months; each one presenting a superb opportunity to go long or short the SVXY.

The SVXY (Inverse of the near-month futures contracts on the VIX Volatility index) is approaching the extreme upper edge of its trading range.

The first time I visited Tampa Bay, FL, I was amazed at the placid, almost serene, waters in the bay. Standing there on the shore, it seemed improbable to me that the same bay could be whipped-up by a storm of gale-force winds, capable of shredding the white sandy beach I was standing on. It looked so peaceful, otherworldly even, and definitely far from anything turbulent.

Yet volatility events in the market can be like that. They seem to come out of nowhere, and after a time of great stability and profit too, when you least expect them.

A time like now.

Hurricane season in the Gulf begins with the onset of summer. And in each of the last 4 summers - 2010, 2011, 2012, 2013 - the stock market has had its own version of a perfect storm. Remember the Eurozone Crisis; the BP Oil spill; the crash of the bond market, fixed income, and the Fed's Taper Tizzy?

Nobody planned for them.

We have had the recent re-emergence of Cold War tensions in Ukraine to show us how quickly political events can overtake economies. The Ukrainian crisis resulted in volatility spikes worldwide in March and April, and a catastrophic drop in the Russian stock market.

What kind of fundamental event would signal an upcoming correction in the U.S. stock market? First of all, we are in year 2 of the Presidential Cycle, a time when stocks usually consolidate after a heady year 1 (2013).

Secondly, there is the somewhat reliable "January effect", in which the first 5 trading days of the new year are a good rubric for the remainder of the month. The first week and the first month piggyback, thus intensifying January's effect on the year. A down week 1 for a new year - followed by a down January month - is not a good portent. It has led to 10% corrections in 7 of the last 7occurrences.

Next is the age of this bull market (63 months; the average is 44 months); and the cues which begin to develop at the top of a market. The number of new highs has been steadily declining for a year. Deterioration in the Russell 2000 Small Cap index (RUT) is another sign of a top. Many of those stocks are already down 30% from their March highs.

What has masked the selling in the small names thus far is the money (demand) is simply being re-deployed into funds that track Large Cap indices (Dow Industrials, SPX 500, and the Nasdaq 100). The passage of leadership into these - the most stable, large cap stocks - is a further sign of the selectivity that occurs in an aging bull market. We now have the curious phenomenon of fewer and fewer (large cap) stocks leading the indices to record highs while the rest of the market languishes.

This is a sign of distribution, not accumulation.

The trigger for an upcoming volatility event would be the re-entry of fear into investors' minds; and fear in the stock market is measured by the VIX volatility index, a ratio of call options to put options on the SPX 500. Here is a simple but detailed description of the VIX.

As you can see from the chart below, the ProShares Short VIX Short-Term Futures ETF (SVXY) - an ETF which tracks the inverse (opposite) of the two front-month futures contracts on the VIX volatility index - has been rising in an unbroken trend for about 6 weeks. (See snapshot from the CBOE for the latest spot prices on these two contracts.) A rising SVXY and a steadily-falling VIX means the market is as calm as calm can be, like my Tampa Bay analogy at the beginning of this article.

I choose the SVXY because it has re-visited the highs and lows of its clearly-defined trend many times these last 3 years. Now the SVXY is approaching the upper edge of its channel again; measured by the convergence of its moving averages (MACD) and the upper limit of its trend-line at $80. It is also approaching the end of a 6 to 8 week cycle that has marked the onset of recent bouts of volatility.

recent bouts of volatility.

Here is another look at the same ETF on a weekly chart, using the %B indicator, which again shows the SVXY near the extreme upper end of its trading band.

(SVXY Weekly)

In the last 18 months there have been 10 volatility events (depending on how you measure the rise in the VIX Volatility Index); each one causing the VIX to momentarily spike for a week or two. These spikes have created superb exits and entries on the SVXY (above).

(VIX 2011-14)

 

On Friday, May 23rd, the VIX hit a 7 year low at 11.36.

(VIX at 7 year lows)

The trade here is to short the SVXY - anticipating an upcoming volatility event in the summer - easing into the short at its current price of $76 in small increments, with a full short position if/when the ETF strikes the $80 mark.

The 5 previous reversals ranged between -16% to -35%. A conservative place to cover would be at $65 (note the dotted blue line on Chart 1), although it could go lower, to the bottom of the channel (similar to February, 2014).

And how would the SVXY perform under the aforementioned scenario of a 10% correction on the Dow Industrials and SPX 500? That would be an outlier, but if it happened, it would be the largest drop in 2 years, as much as -40% or more on the SVXY.

At this point in the VIX cycle, I see the risk as being more to the downside, not the upside, and thus this trade as an option for playing the potential for some forthcoming volatility in the summer months.

Insurance is always cheapest when you think you need it least.

Published at Seeking Alpha

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