Historical volatility is a measure of price variance for an asset. Implied volatility is the market’s perception of future price variance. The price of an asset at any time is always the correct price because it is the level where buyers and sellers meet in a transparency environment, a market. The VIX index trades on the CBOE tells us the market’s opinion on where implied volatility will be in the future.
Meanwhile, implied volatility is the most significant price determinate of put and call options. When implied volatility rises, put and call options become more expensive. When it falls, the premiums or cost of the options decline.
Without getting too theoretical or mathematical, it is best to think of the VIX futures as an indicator of the future volatility of the market’s price variance. A rise in the VIX tells us that market participants expect wider price ranges and often lower prices.
Options are price insurance. Insurance buyers tend to purchase protection during periods of uncertainty. The VIX futures are a derivative product that hedgers and speculators use to either protect a long or short position or participate in a market move. The Velocity Shares Daily 2X VIX Short-Term ETN product (OTCPK:TVIXF) is a short-term product that magnifies the VIX index’s price action.
Volatility tends to rise during corrections
The weekly chart of the E-Mini S&P 500 futures contract shows three stock market corrections in 2020.
The chart highlights the price carnage from mid-February through late March that took the E-Mini 36% lower. The correction in September caused a 10.8% correction. The most recent downside turbulence came just before election day in the US as the E-Mini slipped by 8.9%.
The chart shows that the VIX index rose to over 85 in March, above 38 in early September, and over 40 at the end of October when the stock market suffered corrections. At the end of last week, the VIX was back at below the 23 level.
The VIX has declined back into buying territory
At below 25, the VIX has declined to an area where buying volatility was the optimal approach through most of 2020.
The chart highlights that the 20-25 level has been the buying zone over the past six months.
Three reasons for corrections over the coming months
The most compelling reason for another potential rollercoaster ride in the stock market over the coming weeks is the rising number of coronavirus cases. The CDC and many healthcare professionals have warned of a “dark” winter as the next wave of coronavirus cases descends on the US and Europe. The number of confirmed US cases is rising and could reach 200,000 per day or higher. While companies are hot on the heels of a vaccine, it will not be available in time to stem the current trend of sickness and death. The mortality rate may be falling, but people are still contracting the virus at an alarming rate. New lockdowns are already occurring as New York City closed its schools and other cities are announcing measures to stem the spread. The virus continues to weigh on the economy.
The January 5 runoff Senate contests in Georgia will determine the majority in the US Senate. A victory by the two Democrats would hand the gavel from Kentucky Senator Mitch McConnell to New York Senator Chuck Schumer. A 50-50 split in the Senate would give Vice President-elect Harris the deciding vote. The markets seem to prefer gridlock and a Republican majority. Separation of powers between the government’s political parties would create checks and balances to temper substantial shifts towards a more progressive agenda under the Biden administration. A majority of Democrats in the House of Representatives in the House and Senate would likely push the President-elect to the left. It would negate the need for compromise on his legislative plans. We could see lots of volatility in the stock market in the coming weeks as Georgia will decide if there will be dramatic changes in taxation and regulatory policies in 2021.
Finally, the stock market is near the highs, which increases the potential for a correction as gravity can be a powerful force. The technology sector, which led the market higher since the March lows, faces bipartisan agreement when it comes to the antitrust considerations because of the economic power created by cash hordes and market caps and their control of data. A significant correction in the technology sector could trigger selling and risk-off conditions in the overall stock market.
Timing the market with discipline
Timing is everything when it comes to trading in markets across all asset classes. It is one thing to call the direction of a market over the long term, but another to execute risk positions to take advantage of market volatility.
The most successful traders and investors do make the right moves all the time. They know that attempting to pick bottoms and tops in markets is virtually impossible.
Discipline by using stops and constructing a logical risk-reward approach to markets separates winners from losers in markets. Following trends to take the meat out of moves creates the highest probability of trading profits.
The Velocity Shares Daily 2X VIX Short-Term ETN product (OTCPK:TVIXF) magnifies the volatility in the VIX. The leverage in the TVIXF product comes at a steep price, which is time decay. Therefore, timing is the most important consideration when using TVIXF and other leveraged products.
As the chart of TVIXF illustrates, the product followed and magnified the VIX’s price action during the most significant moves in 2020.
TVIXF is a useful trading tool
TVIXF is only appropriate for short-term risk positions on the long side of the VIX index. The fund summary for the product states:
Source: Yahoo Finance
TVIXF has net assets of $375.37 million, trades an average of 36,087 shares each day, and charges a 1.65% expense ratio.
I use products like TVIXF for short-term long risk position in the VIX when it dips into the buying zone. I use price stops that reflect a higher reward than risk and employ time stops as the leverage makes the product decay when the VIX moves lower or remains within a tight range. The risk-reward balance must account for many more losing attempts than capturing a significant move. However, products like TVIXF can offer substantial rewards over short periods that cover short-term losses and provide substantial overall gains when the VIX spikes to the upside.
I expect volatility to return to the stock market over the coming weeks. At below 23, the volatility index is back at a level where risk-reward favors the upside. Tight price and time stops are essential when considering the TVIXF and other products that magnify expected price moves.
The Hecht Commodity Report is one of the most comprehensive commodities reports available today from a top-ranked author in both commodities and precious metals. My weekly report covers the market movements of over 20 different commodities and provides bullish, bearish and neutral calls; directional trading recommendations, and actionable ideas for traders.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.