“Fear incites human action far more urgently than does the impressive weight of historical evidence.” -Jeremy Siegel
Wall Street is expert at making people feel afraid, incompetent, and inadequate. Or at least the more bearish sections of it are. Without the fear, given the proliferation of modern financial instruments, there is really very little reason to hire Wall Street and wealth managers other than the superficial peace of mind that is attained. It's always important to remember that Wall Street are the highest paid people that consistently fail at their job over time: beating the benchmark.
If you have the time and intellect, the instruments available to you have created a lot of opportunities for alpha for retail traders. The modern asset landscape and the evolution of risk instruments decidedly favors smaller players and retail investors if they can navigate this new world properly.
One of the things that complicates the process of day trading is that the types of research available for long-term and short-term investors are typically different. Traders tend to take a heuristic that being directionally agnostic and playing straight probabilities based on historical data.
They take an approach that is more similar to valuing sports bets than it is to macro research. And at the time horizon they operate it, and given their volume of transactions, that makes sense. They are machine gunners. We want to be snipers at Punk Rock Traders. We want to pair the probability analysis with directional conviction to achieve outsized returns.
The CBOE Volatility Index is steeped in fear and mystery. Hell, it's even called the Fear Index. And trading this instrument is the subject of this column. We don't get into the financial math too often that typically undergirds trading strategies, instead we try to give people who already have this knowledge directional analysis to help them maximize the impact of their other type of research.
We offered you two successful VIX shorts following the massive spike on August 5th. Then last week, we got you into $VIX calls that had price spikes well into the triple digits on the VIX spike last week. This gave you ample opportunity to capitalize on last week's volatility. The $VIX spike on August 5th was the third largest in history and has elevated interest in the fear index, as you can see above.
Now the $VIX term structure inverted last week. One of the reasons I was able to call an imminent collapse in volatility on August 6th is because you can break $VIX spikes into two qualitative categories.
Spikes where uncertainty is shortly resolved and the underlying catalyst does not match initial fears. Most risks that cause markets to fall have more bark than bite. So if the VIX inverts and rapidly normalizes, you can bet on further weakness with a good historical track record.
Spikes where uncertainty remains are far less common, but one of their identifying features is that the VIX curves stays inverted. COVID and the Global Financial Crisis are two examples of extended inversions due to persisting uncertainty.
I think it is very clear that both the spikes in August and earlier this month were of the first character, not the second. The elevated interest in the VIX also means that its is abnormally high in the public consciousness which likely means a higher than normal amount of people bought upside exposure to the VIX. Afterall, most market participants chase the trend instead of anticipate it.
Everyone knows that the VIX is seasonally high in September! We all remember the Great Financial Crisis. Only when you drill down on seasonality and when you consider that we recently had two large VIX spikes, it becomes a pretty reasonable assumption that we will see some calm in the index for the next few weeks. Even when taking seasonality into account. When you look closely, you can see that there is a seasonal drop in volatility in mid September. That is what we will be playing with this trade.
Furthermore, since we had a a VIX spike last week of nearly 50%, the qualitative insight would likely be that the next spike will be October at the earliest. But despite seasonal volatility, the market low rarely occurs in September. It mostly occurs in October or August. So odds favor a rally after the steep losses last week, which were about the same in magnitude as early August, but with a much lower volatility spike.
I think there is a higher chance than average that we miss the typical seasonal spike if the election becomes less contested in either direction given the size of August's spike, but it's always dangerous to disregard seasonality. But even so, when we drill deeper into seasonality, we also see that there is better odds for low volatility and better market returns if we are not in a recession.
I think the data clearly indicates we are not in a recessionary environment but rather a soft landing environment. The labor market is still growing, but slowing. The consumer is strong, gas prices are low, and inflation has been largely vanquished from being a primary concern for financial markets. The Fed is about to begin a cutting cycle, and the carry trade is no longer an unknown for markets. All of this fundamental underpinnings coalesce with my seasonal analysis to make me think there is a little window of calm that we can exploit in a trade.
Buy the October 2nd $17 put options on the $VIX. The time value is very low and these options will be highly risky and volatile in price. These opened today at $0.67 cents. I think they are cheap.
You are at an extreme risk of losing your entire investment. On the flipside, taking more risk at this time of market uncertainty can lead to outsized gains.
If you don't understand the risks of options and the Greeks, don't even think about entering this trade. It's going to be like flying a helicopter in the eye of a hurricane, but I wouldn't recommend it if I didn't think it would not resolve favorably.
As I said above, I really can't stress how high risk this trade is. But that's why they call us Punk Rock Traders. I think there is high potential to shoot and scoot on this trade and get out with an intensely appetizing price gain. I am still advising you hold onto the longer term November expiry VIX shorts I've already recommended in anticipation of a post-election volatility crush. I also still believe a VIX spike in October is a high probability outcome given election uncertainty, but we have plenty of time before that, my dear Punk Rock Traders.
