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Volatility Shifts (VXX/VXXB) – Will You Be Ready?

by | Jan 18, 2019 | Bishop's Corner

The markets are raging this morning… but are we getting too comfortable?

When you get comfortable, you let your guard down. You’re less fearful, maybe even overconfident, because you know the road like the back of your hand. However, that overconfidence makes you lazy, and lose focus… and that’s typically when something bad happens.

More than half of America’s car accidents happen within five miles of a person’s home, according to a Progressive Insurance study.

In the stock market we use terms like fear, greed, and complacency to describe investors’ sentiment. Traditionally, traders have been using the CBOE Volatility Index (VIX) as a benchmark to measure fear and greed.

You see, if you understand how the VIX moves or know someone like myself who can explain it to you… you’ll have better insight on when to buy and sell stocks, exchange-traded products (ETPs), and options… as well as when markets are overheating and when we’re nearing a market bottom.

It’s Friday, and the markets are celebrating another green day… but I’m looking at internals, the stuff under the hood. And to be honest… I’m pretty concerned.

But before I dig deeper into the VIX and the upcoming changes we’ll be seeing. I want to give you some historical perspective. A high VIX value means the market is scared, a low VIX means the market is complacent and the bulls are having their way.  

During the financial crisis of 2008, it hit a record (intraday high) of 89.53.  Not too long ago, the VIX got as high as high as 50.30 on February 6, 2018, the day after the S&P 500 dropped by 4%.

However, when stocks were hitting all-time highs the VIX was crashing…and it remained low for a while… up until last October. That said, the VIX closed at 36.07 on Christmas Eve.

But guess what?

The market is rocking now…

In fact, it’s up about 13% since the government has been shut down.

No, the US and China haven’t come to trade terms yet. And no, the government doesn’t look like it will be reopening anytime soon.

It seems like there is still plenty of uncertainty. Especially, when you consider we are early in the earnings cycle.

It’s all getting overlooked. Because as I’m writing this while the VIX is below 18… closer to 17.

But you know what?

Big changes are occurring at the end of this month…these changes could have major consequences on the overall market.

Here’s what you need to know and how to be ready for these volatility shifts.

Volatility Trading – VIX Recent Historical Example

When the market is overly complacent, and a majority have the buy the dip mentality… that’s when volatility could kick in… and smoke the short volatility traders out of their positions.

For example, here’s a look at the VIX in 2017.

2017 was the least volatile year in the VIX in decades. Heck, the VIX was below 9. Traders were shorting volatility on pops, heck they were even buying XIV at the time… thinking the market would just keep stepping on the gas pedal and push to new all-time highs.

The short volatility traders were complacent, shorting volatility near the lows… You see, volatility has a capped downside, it can’t fall below 0. Moreover, a low volatility environment is not sustainable.

Now, what happened to those short volatility traders back in February 2018?

Well… a lot of them probably got forced out of the game.

Here’s a look at the insane move in the CBOE Volatility Index (VIX).

Think about shorting volatility at 15, only to wake up and see the VIX hit 45.

Now, there are some ways to potentially spot moves in volatility. For example, when I see the blue line cross above the red line, as annotated in the chart above, I would look to be long volatility.

Moreover, when you are short volatility, it’s nearly impossible to know how much you could lose. For example, traders who were naked short VIX call options around early February 2018 probably lost multiple times what they were expecting. Additionally, this volatility spike caused the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) to go defunct.

There are a time and place for being short volatility, and it’s a very risky trade if you want to short VIX below 20…

You’re probably wondering, “How do I get long volatility?”

Well, there’s going to be some rotation in volatility products. You see, volatility exchange-trade notes (ETNs) are similar to bonds and have a redemption date. The widely-traded VXX will cease trading on January 30, 2019… but long volatility traders still need their fix.

Enter VXXB

Now, institutions aren’t just going to get rid of volatility products. They actually created a new one to prepare for this change. You see, these ETNs have a maturity date just like bonds. Barclays initially set the maturity date for the Barclays iPath S&P 500 ST VIX Futures ETN (VXX) only 10 years from the inception. However, since this was the first “real” volatility exchange-traded product (ETP), they didn’t know how things would pan out – this being an experiment and all.

To continue generating earnings in this space, Barclays created a new volatility ETN – the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB).

This is more or less the same as VXX. VXXB was introduced to the market on January 17, 2018 and Barclays set the maturity date 30 years from its inception. However, as shown in the ETN’s prospectus, Barclays could redeem the ETN prior to the maturity date – just as it did with XIV last year.

If you’re already long or short VXX, you’ll need to plan accordingly. If you’re short VXX and do nothing, your position would most likely be called prior to the maturity date. Now, you’ll have to double check with your broker on that one. However, it’s best to be proactive with this so you don’t get an unfavorable call-back price.

For VXX longs, you’ll want to contact your broker and ask if they offer an exchange program for VXX. If they do, they would swap your VXX shares for VXXB shares. If you don’t contact your broker, you’ll have to figure out a day and place a limit order to sell VXX, while simultaneously purchasing shares of VXXB.

Now, VXXB trades around 850K shares a day right now… however, after VXX ceases trading, I think the activity would pick up.

Moreover, around that time is when earnings season really starts to pick up. We’ve got Apple Inc. (AAPL) reporting that week – keep in mind the company already cut its guidance earlier this month. That said, I think corporate earnings and this shift in volatility products could cause the market to get out of whack.

Spikes in volatility don’t need to scare you. Instead, look at them as opportunities. If you’re unsure how you can, check out this complimentary training.

To YOUR Success!

Jeff Bishop

P.S. Petra Hess helps people trade  with confidence. She doesn’t believe that trading needs to be complicated in order to make money with stocks. She uses one simple indicator to pick her trades. Find out how she’s made over $2.6M in trading profits and how you can replicate her rules-based trading style here.

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