VIX & VIX Futures Still Overvalued

 - Last Friday, VIX front month futures closed 22.7% above FVEF Indicator, which was the most "overvalued" in 5 years.  I honestly thought either this is the most opportune time to short VIX futures or my model is "not working", which undoubtedly put me at great unease.

- Well, from last Friday's close to Tuesday's low, VIX front month futures plunged from 28.25 to 22.85 or 19.1%.  In fact, VIX front month futures fell to par of FVEF at its lows on Tuesday before jumping up again.


- As the red line shows on the top chart, FVE has actually been falling this entire week, which was an indication that the underlying market was becoming more stable.  As shown on chart of SPY, we broke out of the short-term falling channel today.

- With all the headlines and fears and Volatility instruments like VIX & VIX Futures spiking up, it is very surprising that the underlying market's fall has been and still is orderly, relatively speaking.  In fact, I'm surprised with all the doomsday scenarios out there, SPY has yet to test the 200-day moving average.  Something is likely to give.  Either SPY has much more to fall or VIX & VIX futures does.  And what VIX futures price action showed me this week is that I should not doubt my FVE model.

VIX Futures in Overvalued Territory!

 - With expiration settlement of May VIX Futures this morning, June VIX Futures is now the front month futures.  Relative to FVEF indicator, VIX futures is now overvalued.  In fact, very overvalued.

- The second chart shows a series of VIX front month futures prices.  The futures over/under indicator compares the VIX front month futures price relative to FVEF on a % basis.  At today's closing price of 24.40, it is 14.1% "overvalued" relative to FVEF indicator, which does not happen often.


- Now VIX & VIX futures prices are in a rising trend, and I had been predicting this rise for the past several weeks.  With uncertainties of global economic health growing, volatility is expected to continue rising, but it is interesting to see that the FVE indicator has actually gone sideways the past few days.

- The current correction, while persistent, seems very orderly--more like buyers are waiting rather than running away.  Are they waiting for a selling climax? or does the market need to rebound from oversold levels before we start to see greater price volatility in the underlying?  If we do see a rebound, VIX futures prices could drop significantly because of the overvaluation.

Efficacy of FVE Model in Relative Value Trading

- Fair Volatility Estimate (FVE) Model is calculated from SPY ETF (underlying) prices while VIX is calculated from S&P500 Index options' (derivative) prices.

- FVE calculates the "Fair Value" of VIX.

- Now, if the above statement holds true, then one should be able to trade VIX relative to FVE--that is buy when VIX is below FVE (because it is assumed to be undervalued) and sell when VIX is above FVE (because it is assumed to be overvalued).  Now let's assume that even if the FVE model could calculate the "Fair Value" of VIX, the "Fair Value" is not a static number.  In strong rising or falling trends, which often materializes in the VIX, what may seem undervalued/overvalued today, may not be so tomorrow...

- Nevertheless, the graph shows a simulation of an $100k account following the Relative Value Trading Strategy utilizing VIX front month futures prices and FVE Indicator modified for VIX front month futures prices.  I call it FVEF indicator.  The trading rules are crude and simple, and I am using the rules only to illustrate the efficacy of FVE Model.  On daily closing prices, Buy VIX futures when its price is 5% or more below FVEF.  Sell VIX futures when its price is 2% above or more than FVEF.  Stay long or short until next reverse trade signal.  Slippage of 0.075 was assumed with $2.50 commission / futures contract.  Finally, in the simulation profits were reinvested but no leverage utilized.

- Yes, that is log scale and compounded annualized return >180%.  Now I'm not claiming such return is likely moving forward, and the drawdowns are significant.  But I've run this simulation back in September of 2011 (not posted) and it still seems to be "working".  Yes, the -5% & 2% values are optimized values but this simulation result is not a result of "curve fitting".

- The biggest risk to the efficacy of FVE Model is the marginal breakdown of the KEY assumption--that underlying market leads the derivative market most of the time.  I believe this was not necessarily the case prior to 2008 market meltdown when options were being utilized en masse by the discretionary investing public, resulting in what I believe was a "tail wagging the dog" situation.  After 2008 market meltdown, I believe on the margin, discretionary options trading has decreased significantly, replaced by HFT and algorithms.  As long as this environment continues, I would believe that the FVE Model would remain effective.

VIX Rising to 24.6 Before May VIX Settlement?

 

● Something interesting happened at close of Friday to VIX.  As you can see from left chart, the green line turned positive (which does not happen often).  The green line is the Point&Figure Trend Indicator found in Metastock Technical Analysis software.  I will not go into explanation of this indicator, but it is a good indicator to use for instruments that exhibit strong moves in direction and scope, such as VIX.

 

● I did some further analysis and found that since 2000, P&F Trend Indicator turned positive a total of 18 times not including the most recent turn, when VIX was less than 25.

● The table shows the max % gain and max % loss of VIX after the P&F Trend Indicator turns positive.  I chose 8 days as a forward looking period because there are 8 trading days (7 + overnight) to go before May VIX settlement.  As you can see, the max % gain of VIX within 8 forward trading days averaged 28.6% and the max % loss averaged -6.7%.  That would mean that the expected range of VIX in the next 8 trading days is 17.9 - 24.6.  VIX closed on Friday at 19.16.  Admittedly, it is hard to determine "expected values" with such a small sample of data.

● I did notice two instances where right after P&F Trend Indicator turned positive, VIX immediately plunged (highlighted in yellow in the table).  First was on 3/22/2004 and second on 3/13/2007.  (see third chart, dates in blue circles) I do not believe the market environment on 3/13/2007 is similar to the current market environment.  In particular, VIX had already risen 80% from recent low then of 10.02.  March 22, 2004, however, could represent a similar market environment to that of the current one.  There were concerns then about steep valuations and the market having come up too high too fast.  Here are 2 links after a quick google search that can provide some market color on March 22, 2004. 1)http://www.hussmanfunds.com/wmc/wmc040322.htm and 2)http://finance.groups.yahoo.com/group/investorguide/message/223.  One thing is common with both dates however.  The P&F Trend Indicator reversed to negative just 2-3 trading days after it turned positive--meaning that if the latest signal results in a whipsaw trade, one would likely not have to hold the position for the entire 8 days and incur maximum losses.

● Unfortunately, VIX is not an easily tradeable instrument.  One could buy May VIX Futures.  It closed on Friday at 20, which is 4.38% premium over VIX.  While the average premium with 8 days to go before expiration has been 1.96%, if we put in a filter with VIX <25, the average premium of VIX futures over VIX has been 4.73%.  One could buy the VIX May 19 calls at 1.95...Or perhaps a superior risk adjusted strategy may be to buy the VIX futures spread (buy May, sell June or July) or buy VXX and sell VXZ as a pairs trade.  Should VIX jump, the front month VIX futures should rise considerably more than the back month VIX futures.  Of course, if we get negative market impacting news from Europe over the weekend, the opportunity to make a trade on this analysis may have slipped away...

● Finally, VIX has been moving incredibly close to my FVE model for the past several weeks.  Looking forward to Monday, my Fair Value Estimates for VIX are indicating ~19.5 (SPY rising 2%), ~19.3 (SPY rising 1%), 19.5 (SPY unchanged), 19.7 (SPY falling to 136), and 20.1 (SPY falling to 135).  On Friday, VIX closed at 19.16 while FVE closed at 18.9.

VXX/VXZ Pairs Trading Strategy with FVE

- On my February 22nd post, I illustrated a trading strategy using VIX Futures Term Spreads incorporating the FVE Model.  This time I ran a simulation executing a pairs trade strategy using VXX & VXZ.

- The blue line on the left chart shows the equity graph of the VXX/VXZ pairs trade.  From 2/26/2009 to 5/2/2012 this strategy generated $29,529 in simulated profits.  Annualized return of 32% on a $20k account with max drawdown of 11%.

- The pink line shows the equity graph of a simulated 2nd/3rd month VIX Futures pairs trade.  This generated $54,414 in simulated profits.  Annualized return of 51% but the max drawdown was 32%.  While the VIX Futures pairs trade may appear to be a superior strategy, on a risk adjusted basis, the VXX/VXZ pairs trade strategy beats the former strategy hands down.  Mar ratio (annualized return / max drawdown) for the VXX/VXZ strategy was around 3, compared to 1.6 for the VIX Futures pairs trade strategy.

- I will revisit these two strategies a few months from now to see if they would continue to generate strong (theoretical) profits based on buy/sell signals from my FVE model.