Today, I’ll show how the risk characteristics of this market have been evolving over the last six months. I won’t use traditional price charts or volatility assessments; instead, I’ll show a perspective of how risk assessments exhibited by VIX futures traders have been changing.
If you’ve read my work in the past, you’re familiar with the concepts of contango and backwardation of futures curves; if so, you can skip the following chart and one paragraph – but only one.
VIX Term Structure, December 2018 vs. December 2019
Source: Michael Gettings Data Sources: VIXCentral.com, CBOE
Compare the plot of the first four VIX futures contracts during a high-risk (December 2018) market and a low-risk (December 2019) market. Recall that December 2018 was a tough market and December 2019 was a strong rally. It’s easy to see that the shape is sloped upward (contango) during good times and downward (backwardated) during high-risk intervals. I don’t show it here, but the changes and rate of change in SHAPE are important indications of how these sophisticated traders perceive risk.
Enough basics. I quantify the degree of contango or backwardation by averaging the three differences of the first four futures contracts. Positive values are contango, more contango produces higher “SHAPE” values meaning less risk. Negative numbers reflect backwardation; lower values are riskier. Each day produces a new SHAPE reading – more frequently if you want to live in front of a computer and maybe lose some sleep. Those values can be strung together to infer how VIX traders’ risk perceptions are changing. In my quantitative work, I monitor the SHAPE, plus a short-term slope and a medium-term slope to inform decisions, but here I’ll simply show how contango-backwardation trends were evolving through last week.
Evolution of the SHAPE Metric, Last Six Months
Source: Michael Gettings Data Sources: Fidelity, VIXCentral.com, CBOE
The annotations in the graphic tell the story. The “sell” signals of August gave way to an extended rally that carried through last week. The October decline in SHAPE was contradicted by a positive slope as indicated by the purple line. For that reason I called it a bear trap in my October 4th article, “The Easy VIX: I Smell a Bear Trap.” I find it interesting how the period from September through January looks like a slow-motion movie as sentiment rose, peaked, and then fell quickly in late January.
So, I rode this rally for 101 days since my August “Buy” signal; that is until last week. Last Thursday morning I sent out a de-risk alert to Easy VIX Marketplace members, and then Friday after lunch I sent an outright “Sell” alert in anticipation of that day’s closing metrics. My preference is to execute prior to the close when an end-of-day signal is highly confident. Waiting until morning is typically sub-optimal. I sent those alerts because the SHAPE and both slopes indicated the emergence of a dominant risk-off sentiment.
Just to be clear, Easy VIX members make their own decisions and run portfolios of their choice, appropriate to their own risk appetites. Some run conservative portfolios, and some run more aggressive leveraged structures; I simply report on the model metrics and I interpret nuances in the model results as they emerge. I also report on my own trades using a reference portfolio structure.
As a reference, I’ve been using a portfolio of SPY, DIA, QQQ, IWM and a 2X leveraged ETF, SSO, swapping that mix for IEF when an exit signal comes along. In the de-risk alert, I advised that I was selling IWM and SSO; then on Friday afternoon’s sell signal, I sold the rest. Using my basket weightings at this writing, the exit trade holds a 3%-plus advantage.
I’ve emphasized in past articles that I never know when a given “Sell” interval will be a major win or just a small single-digit variance from a buy-and-hold strategy. Modeling of the last 12 years indicates about 7 of 8 intervals are zero-sum noise, while one in eight produces major wins. Live trading since late 2018 seems to confirm the modeling results.
This is the ninth sell signal since I’ve been trading the strategy in late 2018. Of the eight that have been resolved, one captured an 11.3% advantage versus holding while the other seven produced an average gain of 0.79% each. Those reflect avoided ETF losses plus IEF gains. That is generally consistent with the modelling, although the 0.79% gain on the “noise” is a bit high. Usually the small variances produce nothing other than peace of mind in a risk-off market.
This particular drop has come fast and fairly deep, so if prices rebound, I’ll probably still buy back at values a bit better than I sold; if it follows through to the downside, I’ll buy back at bargain prices and ride the next wave upward. The 12 years of data indicates that the methodology produces about double the returns of a buy-and-hold strategy with worst rolling 252-trading-day losses in the low single digits.
So, I don’t know if the current market risk-off sentiment will be a small hiccup or a material correction. I do know that I won’t participate.
If you’ve been riding this market down the past six days through today (Thursday), you’re probably wondering what to do next. I always avoid getting into specific advice; I simply report model metrics and help interpret the nuances of those metrics. This graph extracted for my November 7th article, “The Easy VIX: Sequential Return Risk And Drawdown Protection,” might be of help in that regard. It shows the advantage/disadvantage of each modeled sell interval and I’ve superimposed a yellow box that indicates the 3% gain to date for the current interval. Draw your own conclusions as to whether the 9 larger gains make a late exit worth the risk of the lesser potential outcomes. To be clear, the gains indicated in green are mostly avoided losses with some additional returns from riding the flight to safety via IEF.
Advantages and Disadvantages of Modeled Sell Intervals
Source: Michael Gettings Data Sources: Fidelity, VIXCentral.com, CBOE
So, if you’re riding this market down, hope it’s just a hiccup. As I sit here Thursday at 1:10 PM, the Dow is down 520 points… and I feel fine.
The Easy VIX marketplace service kicked off at the end of October and has jumped to a good start with over 50 members in the first two months. Our primary objective is avoiding significant drawdowns, thereby increasing returns with reduced risk. Behind that pay wall we look at the algorithm’s daily metrics and investigate its applicability to growth portfolios, dividend holdings, and leveraged ETFs for more aggressive investors. If you find any of this interesting, consider a free trial or click the orange button to follow me. I’ll continue publishing free articles, but the meaty stuff is in the Easy VIX members’ site.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I trade a basket of ETFs and any tickers mentioned using the algorithm described. The artificial intelligence algorithm monitors daily performance and periodically recalibrates look-back horizons and triggers in a step-wise sequence. New calibrations are applied prospectively only, and never applied to the historical period from which they were derived. The algorithm described and the discussions herein are intended to provide a perspective on the probability of outcomes based on historical performance. Neither modeled performance nor past performance are any guarantee of future results.