Innoware's weekend Volatility Blog
So, we are in Backwardation!!
Last week was a triple whammy – Volatility shorts got pushed to a corner because backwardation set in, S&P 500 lost close to 60 points on Friday alone and the crypto currency rout continued – all the 3 areas where I invest.
This week end, we are releasing our Crypto book – so you will have a lot to read there. And in my millionaire blog tomorrow, I will cover the fall of indexes last week and how it impacts my Index Investing for long-term period of 10 years.
Let us continue our discussion on Volatility in today’s alert/blog.
First things first, the usual disclaimer once again. This is not investment advice. Please do your due diligence. This exercise is just sharing our knowledge with you.
What make Volatility Trading Interesting?
Volatility trading is interesting because it follows a logic and uses math. So, whether the times are good, or bad, it is much easier to address challenges – unlike other assets where such an edge I have not been able to find.
What is Backwardation?
If you are reading this and are trading volatility and have never heard of backwardation, then you made a big mistake of not learning about the instruments that you trade.
You can download my Trading Volatility book from our website
and give it a read – not once but at least 2or 3 times.
On our website, a user is supposed to enter his/her email id before downloading the free ebook. At the backend, I see some users attempting download 10 to 15 times – possibly they don’t know that the PDF has already been downloaded in the download folder of their computer. Anyway, if you are unable to download the book, do shoot an email to
and it would be our pleasure to email you the book.
On another note, this trading Volatility book is also sold on Amazon.com, Audible and Kindle. Very rarely, I mention this fact, because promoting my book for sale and profit is the least of the objective of mine and Brennan’s. And same is our take on the issue of “Scamming” users with “subscription fees” for all the wrong advice in the world - and there are plenty of such whom we don't want to name here!!
Anyway, put simply, backwardation is where the M1 (current month VIX Futures) is more than M2 (next month VIX futures).
You can observe values of M1 and M2 at http://vixcentral.com
Last Friday (Feb 2, 2018) M1 was at 15.625 and M2 was at 14.965
What is the effect of Backwardation?
Funds that run UVXY and VXX, will, on a daily basis, sell M1 and buy M2. So, in backwardation, they would sell an expensive M1 ($15.625) and end up buying a cheaper M2 ($14.965). This will result in the NAV of UVXY or VXX increasing (thereby increasing their price) – if every day the backwardation continues.
Past data suggests that we are in Contango 95% of the time and we see backwardation only 5% of the time. And that 5% has come now!!
The question is how long will this backwardation last? Will we see normalcy return on Monday? Of will backwardation continue the next week and many more days, with UVXY steadily climbing from $14 to $18 to $20. One needs a crystal ball to predict when backwardation will end and I don’t have that crystal ball. But I can manage my risk and I have detailed that below.
Are we in a Recession / Bear Market?
Definitely not. All tech companies like AAPL, AMAZN, MSFT posted fantastic results (EPS). The employment numbers that came out on Friday beat expectations. Still, indexes were down and volatility is up.
Some say it was profit taking, others say, it is because of bond yields and/or FBI memo leak, Budget deadline, another Government shutdown etc. etc.
99.9% articles that you will read in financial media and other blogs focus on such aspects. So, I will not go there.
I will use my portfolio as an example and list what choices I have in front of me now that we are in backwardation.
Three Choices when in Backwardation
I would suggest that you please read Chapter 16, of my Trading Volatility book. That chapter lists the three clear options that I have, which are:
a) Cash Out completely from the short volatility position and wait it out for normalcy to return
b) Cash out 50% and then continue to be in the short volatility trade
c) Cash out completely from the short volatility trade and enter the long volatility trade
Below, I am taking my own portfolio and commenting my own actions.
Cash Out completely from the short volatility position
I don’t mind taking some risks. If I was a very conservative investor, then I would not be in Volatility trade at all (and instead would be investing in Bank CDs giving me a paltry 0.5% (??) interest). So, my risk profile is such that this option is not for me. There are many more reasons. My capital is adequate. We are not in a recession or a bear market. I consider this backwardation as a temporary phase which will go away.
Cash out 50% and then continue to be in the short volatility trade
I implemented this partially. There is no point in fighting with backwardation. I have shorted UVXY at $8.50 and $9.00. When UVXY touches $14 (and there is a good possibility of it going to $18 or even $20 if backwardation continues and strengthens), then it is better that I be careful. I closed some of my shorts. And then I shorted more at higher price. This was done by selling March 2018 calls – which means that I am shorting UVXY now at $14 instead of the prior $8.50 or $9.00
Cash out completely from the short volatility trade and enter the long volatility trade
Again, I implemented this partially. If you have been following my writings, you would have noted that I always say, cash is my best hedge. I have never bought UVXY calls or UVXY/VXX shares as a hedge in 2017. But for the first time (after writing my Volatility book with Brennan), I bought some UVXY calls yesterday, sold some for swing trade profits and I am still holding some UVXY long calls. I will continue to be in long volatility (meaning buying UVXY calls or even UVXY/TVIX shares) till the time I do not see the full Contango back (or the backwardation disappear). And at the same time, hold the short positons as well.
Trading Volatility Book – Version 2 or a New title?
Interacting with you via daily emails and encountering such periods of backwardation, has made me learn a lot. To such an extent that I have started writing another book, that will solely focus on expanding Chapter 16 of the current book into a full-fledged book of its own. As soon as this is complete, I will share it with you.
When will normalcy return for Volatility Shorts?
This is the question I get asked innumerable times each day when the going is tough. Very difficult to answer. But what I can do is to manage my risk while this headwind is present. I can do many more things like
• Not trying to do too many trades. Slow down and observe where things are headed
• While I would be long volatility as long as backwardation is there, I will be cognizant of the fact that in a jiffy, the volatility crush can happen and I will start seeing my Volatility long position turning towards losses. And I definitely do not want to be holding bags. And at $14, if someone is senselessly buying UVXY hoping to get rich, my comment is definitely we will see a lot of bagholders!
• If I have 1 million dollar portfolio, and had only invested say $200K, I would have doubled down and kept on shorting UVXY now and at regular intervals like $16, and then $18 and then $20. Unfortunately, like all other investors, I do not have “unlimited” capital. So, doubling down is a rather rash move on my part at this stage of my life and my portfolio.
Am I admitting that Short Volatility trade is over and I am a Volatility long like @adallica on StockTwits?
No. First let me compliment my friend @adallica on being a successful volatility long. I have seen UVXY longs come and go on the UVXY board at StockTwits. He is the only guy who has been around for long as a volatility long and I publicly congratulate him on his positive ROI and wish him good luck.
Having said that, being UVXY long is not the copyright of my friend @adallica. Anybody can be long Volatility to hedge or to take swing trade profits and that is exactly what I am doing now (and what I avoid like a plague when 95% of the times we are in Contango).
Not sure if this blog answered your question or raised more questions in your mind. Each investor profile, portfolio and approach is different. Here, I have made an attempt to give you a glimpse of my portfolio and share my knowledge (as much or as little I know).
Thanks and Happy Shorting Volatility
Even if one life is changed by our educational attempts, we would consider our efforts in writing the book a success.
The material in this newsletter, the website http://IndexInvesting.xyz as well as in the book "Trading Volatility - Using the 50-30-20 Strategy" is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. As an investor, you are fully responsible for any investment decision that you make.