I’m going to discuss my highest conviction idea. And I want to explain why I feel so strongly about my chances to make money betting against this security.
Much ink is spilled in the financial press about the “VIX”, sometimes called “the fear gauge.” Simply put, the VIX is a index that tracks the ratio of put options to call options on the S&P 500. If the market is fearful, it will buy up puts as insurance, the reasoning goes. It is an imperfect indicator but it is widely used.
It is not possible to trade the VIX directly but there are a number of securities that strive to provide exposure to the synthetic commodity. All of them do so badly. The securities are intended to be traded for short periods of time, sometimes days or even weeks but usually so badly. The securities are intended to be traded for short periods of time, sometimes days or even weeks but usually minutes or even seconds. Over long periods of time they all decay towards zero.
The volatility tracking securities trade in the futures markets. The most common version buys one month and two month VIX futures and rolls daily to achieve a weighted average future maturity of one month. This introduces a force known in economics and finance as “contango.” Basically, there is more time value on the further out option so each day the fund sells a “cheaper” asset to buy an “expensive” one. To be fair, the further dated future will not always be more expensive. Depending on expectations of future movements in the underlying VIX index, it can go the other way around (known as “backwardation”.) The most popular volatility tracking instrument “VXX” suffers from so much contango it decays about 60% per year!
But it gets worse than a mere 60% a year loss. There are volatility tracking securities that do far worse. Barclay’s VXX product proved very popular among traders. But some traders couldn’t get enough. They loved having a contrarian “investment” that could rise rapidly when the markets were falling (there’s that backwardation again!) VXX has more down days than up days but traders aren’t always rational when their greed and/or fear is engaged.
The traders demanded a leveraged version of the security. UVXY was born. This security does what VXX does but borrows a dollar for each dollar of fund value to purchase the VIX futures. Because of some peculiar mathematics when it comes to percentage declines versus increases and the power of compounding, UVXY actually decays more than twice as fast as VXX. It is a real dog and wins my personal award for “the worst security in America.” Annual declines since inception have been between 90 and 95%.
Out of curiousity, I recently did a study to see what all rolling 52 week periods look like for UVXY since inception. I found that the very best 52 week period yet found UVXY declining 74.15%. This miserable performance attracts my attention because it provides what appears to be a very high percentage opportunity to profit from decline.
Ordinarily I sell options rather than buy them. Because the largest component of an option’s value is usually time value, you primarily purchase a wasting asset when buying an option. The opportunity in UVXY is so reliable however, I am happy to suffer a little time decay.
To profit from a declining asset, you buy a “put” option. This is a contract between you and a counterparty whereby the purchaser gains the right, but not the obligation, to sell an asset for an agreed upon price up until the time of contract expiration. If the underlying asset declines in value, below the agreed upon price, it is a simple matter to buy the asset in the market at a discounted price and then sell at the higher contracted price; keeping the profit spread.
In this case, because UVXY can spike up for short periods of time, we want options with a far distant expiration date. That is, we want lots of time to be right so we don’t get caught on the wrong side of the trade in case there is a backwardation event. The furthest available expiry is 20JAN2017. These are the options I will be buying.
This morning I placed an order for 20JAN2017 expiry UVXY puts with a “strike” (agreed upon selling price) of: 26. I paid $1878.00 for the contract. I will hold the contract for an intermediate amount of time but most likely significantly less than one year. My exit will come when the value of the option increases 10% to $2066.00. I will keep you all posted on the progress.