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The following is a reprint of the market commentary from the January edition of the Option Advisor, published on Dec. 27. Prices and the chart are as of the close on Dec. 27. For more information or to subscribe to the Option Advisor, click here.
Last month in this space, I discussed what I described as "the biggest stock market 'fail' of 2012" – the 75% year-to-date decline in the iPath S&P 500 VIX Short Term Futures ETN (VXX), and the fact that this VXX implosion was reflective of the monumental losses incurred this year by those (heavily populated by hedge funds) who attempted to "buy volatility" as a hedge against a major decline in the stock market. These huge hedging losses may explain (along with a general aversion by hedge funds to equity exposure, a case in which the sentiment of the so-called pros eerily echoes the epochal fear and loathing of equities by the general investing public) the "barely above break-even" performance of hedge funds in 2012 in the face of equity index benchmark returns in the 10-15% range.
About 6 weeks have now passed since my December issue commentary, and the VXX is still approximately 75% lower than where it started the year. But more recently there have been some major twists and turns, as market volatility took a further tumble, culminating in the VXX year-to-date loss peaking at slightly above 80% before doing an about-face as "fiscal cliff" concerns loomed more urgently. In fact, at its high today of 35.88, the VXX had rallied by over 28% from its 52-week low of 27.94 set just 6 trading days ago.
So where do we go from here on market volatility? Attempting to divine this is no mere academic exercise, as the answer will likely go a long way toward revealing (and explaining) the direction of the stock market over the critical beginning months of the New Year. Will the "protection trade" finally prove its value to those whom it has been bleeding dry? Or will volatility continue its inexorable downward march, interrupted only by well-contained peaks during periods of unusual investor worry or distress? The accompanying daily chart of the VXX over the past 15 months (along with its 80-day moving average) may help us piece this puzzle together.
Constant readers of this space are aware of the emphasis I place in my chart analysis on moving averages, particularly those off the road that's very heavily traveled by such "textbook" moving averages as the 50-day and the 200-day. Two of my favorites for shorter-term analysis are the 40-day and 80-day moving averages. The 40-day can often identify entry opportunities that followers of the 50-day will miss, and the "slower" 80-day often serves to provide less noisy entry points than the 40-day, and a greater measure of consistency, while still allowing the trader a leg up on those who follow the traditional 200-day moving average. And the 80-day moving average for the VXX has not disappointed. As indicated on the chart, note how the move below the 80-day moving average late in the fourth quarter of 2011, followed by an unsuccessful attempt to re-take the 80-day, was indicative of the beginnings of the VXX decline that, with some bumps along the way, has carried into December 2012. Note as well that the "bumps" in the form of counter-trend VXX rallies were concentrated in the May/June 2012 period, which were contained at (or for some brief periods, slightly above) the declining 80-day moving average.
The fact that today's VXX rally managed to penetrate the 80-day on an intraday basis but then closed back below is by no means infallible as an indicator that volatility peaked in today's session and has nowhere to go from here but lower. The 80-day is one of many "place markers" for VXX price action. And while I do find it additionally interesting that the VXX also failed to sustain a move today above the level that corresponds to a 75% year-to-date loss (and above yet another level representing a 25% gain from its recent lows) these are, once again, just some additional place markers of which all traders should be aware but that come with no guarantees.
But the idea of developing these place markers is to allow us to create an edge in our directional forecasting compared to that of the crowd, and in this regard the fact that the CBOE Volatility Index (VIX) also managed to be turned back just shy of the key 21 level today is of more than passing interest. Since June, all VIX rallies have been capped at 21 on a closing basis, and today's VIX high was 20.90. Todd Salamone provided some fascinating insights into the dynamics and the significance of the VIX "cap" in the 20-21 area characteristic of the second half of this year in this week's Monday Morning Outlook. So we have yet another place marker for an argument that the year-end volatility pop will likely be contained not too far from current levels.
The perversity of the financial markets, while fairly well known, is rarely appreciated to its full extent. Explosions in volatility have a very strong tendency to occur at junctures when they are least expected and against which they are very sparsely insured. In fact, the crash of 1987 culminated a period during which the preferred strategy in the index option markets was to sell naked puts on the S&P. So not only did such players go unprotected against a crash, their losses as the market plunged actually accelerated as the puts they had sold surged in price. In 2012, we have had an epic battle between a community of hedgers that increased the size of their bets throughout the year even as their losses from such activities mounted and a market that simply refused to cooperate – in part (and perversely) because of the very fact that so many hedges were already in place. Yet the hedgers have not backed down, as indicated by the record VIX call open interest that has characterized the 5 most recent VIX option expirations. But this is not a battle between an irresistible force and an immovable object – the only entity in this conflict that can be so described is the market. So my conclusion must be that unless and until the white flag begins to be waved by the hedgers in the form of a sharp decline in VIX call open interest, the immovable object should continue to prevail.