XIV Loses Its Mind, Correlation Explanation for Low VIX

There's huge upside risk involved in being short March VIX futures at current levels

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"Also of interest is CBOE Volatility Index (VIX - 10.85) futures call open interest, which -- at 7.1 million contracts -- comes into this week at its highest level since August 2015. But on Wednesday morning, more than 3 million of those calls, or 45%, are set to expire. As I said last month, it is usually after a huge number of VIX calls expire that we are most vulnerable to a volatility pop, and volatility pops usually occur in the realm of market weakness.

"The latest Commitments of Traders (CoT) data shows large speculators' short positions on VIX futures are coming off a record level -- and if some of these speculators have February VIX calls as a hedge, that means the hedge is no longer in place as of this Wednesday. And the last time large speculators began covering from a record short position, in September 2016, the VIX spiked, as you can see on the chart below. This is a risk worth keeping on your radar, especially if the market gets spooked by the Fed or by disappointing news out of the White House."

     -- Schaeffer's Senior V.P. of Research Todd Salamone, Feb. 13

Bernie Schaeffer (BGS): Todd, I found your Monday Morning Outlook comments on VIX to be very interesting, and now even more so in light of:

  • Tuesday as the final day of trading for VIX February front-month options
  • Total VIX call volume yesterday of 970K contracts, in the 98th percentile of VIX call volume over the past year (with just 300k of this in February call volume, per Trade-Alert)
  • Tuesday’s cash VIX close below 11
Perhaps that strange-looking downside hiccup on Feb. 1 that took the VIX down to 9.97 was telling us something about how February expiration would play out?

And of potentially even greater significance than the low cash close (if I’m interpreting correctly) is the level at which the new front-month March VIX futures contract begins trading. At Tuesday’s closing price of 12.30, March VIX futures start their term as front-month contract roughly 2 points below the level at which December, January, and February futures started as front month (in the 14-15 area). And 12.30 strikes me as a very disadvantageous price point at which to be short March VIX futures -- because unless March futures will ultimately trade down well into all-time low territory (below 11), one could argue that profit potential is at best 1 to 1.5 points (and we know their huge upside risk, if wrong about VIX direction).

And did the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) finally lose its mind completely? Piling on a 4.66% gain yesterday to peak just below $70?

Actually, the exact prices are interesting: XIV peak on Tuesday (an all-time high) at $69.81; +50% year-to-date level at $70.13. Also interesting is the fact that on Friday, the XIV peaked just shy of double its Nov. 3 low (at $65.37), and then on Monday it just blew by that level on the opening gap.

xiv daily chart 0215

Todd Salamone (TS): And when XIV peaked in October 2016 at $41.52, it was double the June 2016 low around $20.21 and about one week after the expiration of October VIX options.

BGS: For what it's worth, I have never seen a 20-day Relative Momentum Index (RMI) reading for any equity at any time as high as the 94 registered yesterday for XIV (but I probably could also have said this two weeks ago).

I’ve seen lots of talk about a sharp decline in correlations in the names underlying the S&P used as an explanatory narrative for the muted VIX level. Perhaps, but when I did my review of potential February Expiration Week Countdown plays, I found some astoundingly low implied volatilities among individual equity options.

TS: I made a comment on the floor earlier this week that it is unusual to see an explanation for a low VIX. Usually you might see something along the lines of, “Since the VIX is low, the market is primed for a pullback”-type mean-reverting mentality.

I'm not sure how much weight to put into the VIX observations at present, as it seems like a reasonable explanation -- although one might also argue, with Yellen on Capitol Hill and an uncertain political environment, a case could easily be made that the VIX is indeed too low. If we see the VIX double from here as the enormous VIX futures short position is unwound, I could see myself looking back to the rare explanations for why the VIX is low and saying, “That proved to be a contrarian indicator.”

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