Should You Take Your VIX Cues from Hedge Funds?

In the hypothetical words of legendary volatility trader Yogi Berra, shorting CBOE Volatility Index (VIX) is so popular, no one goes there anymore.

"Betting against market turbulence is losing its allure with hedge funds.

That's the signal from futures tied to the Chicago Board Options Exchange Volatility Index, where the spread between long and short positions has jumped to the highest since at least 2004, Commodity Futures Trading Commission data show.

…Hedge funds and other large speculators in VIX futures held about 87,000 long positions and 71,900 short ones through Feb. 3, CFTC data show."

On the surface, that doesn't sound like a big deal. But remember, these are high-roller professionals we're talking about. And by and large, they hold net short volatility positions.

One thing we virtually all agreed upon in the Great iPath S&P 500 VIX Short-Term Futures ETN (VXX) Debate of last week is that VIX futures tend to trade at premiums to VIX itself, and that premium erodes as the futures approach expiration. I'd add that VIX itself proxies an estimate for the course of realized volatility over the ensuing 30 days, and that estimate is generally higher than the realized volatility in the rearview. Thus, VIX itself generally prices in an uptick in realized volatility, while VIX futures anticipate an uptick in VIX itself.

Roll it all together, and finding a way to short something VIX-related is an attractive position. You're a de facto insurance company selling "policies" to the risk averse and the dip speculation crowd. Of course, you need enough capital to withstand the periodic explosion of "claims." But over time, it's a good trade, hence the attractiveness to deep-pocketed hedgie types.

It's not tough to see why that trade has gotten less attractive in 2015. Ten-day realized volatility has hovered in the mid- and high teens for a couple months now, so there's little to no VIX premium. And going one step further, the futures term structure is relatively flat, at somewhat small premiums to VIX.

This all begs a question -- are the hedgies smart money or a contrarian tell?

Opinions always vary on that sort of thing. I tend to view these through the lens of whether the behavior makes sense or not given the backdrop. If it's intuitive -- i.e., buying calls within an uptrend -- I don't find much signal. If it's counterintuitive, such as buying puts into an uptrend, I believe it's a contrarian tell.

So, to me, there's not much signal in this VIX flip. Most of the time, it makes sense to short all things VIX for the reasons above … but now? Not so much. You're simply not getting enough excess premiums on any level to absorb the risk of another uptick in volatility (or even stabilizing at current volatility levels). I wouldn't go chasing VIX here, but I'd want better prices to sell some "insurance."

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.