4 Reasons I’m Shorting The VIX Despite Geopolitical Risks (VIX)

Never take advice from anyone in a tie. They’ll bankrupt you. Don’t ask a general for advice on war, and don’t ask a broker for advice on money.

-Nassim Nicholas Taleb

The unexpected attack on Israel reminds us that we live in a volatile world. Unforeseen risks and tragedies can always occur, but as investors, we must coldly evaluate their impact on markets and commerce. As human beings, it would be nearly impossible to respond to such a tragedy without emotion and sadness.

But as investors, we must look at the implications for markets, and despite the shock, I think Israel’s military dominance is ultimately unshaken by these attacks. The blow was psychological and tactical, not strategic. Israel is a mighty country, and I think her military prowess gives potential regional state adversaries pause, which limits the potential for a regional conflagration. Of course, the last two significant events impacted Israeli markets, but the impact on global equities was relatively limited.

We should all be praying for the victims and their families, and we should all be asking ourselves stark questions about the future of the Middle East. Still, we should also remember that financial volatility, while redolent of physical volatility, is not the same thing. We must remember that the market’s collective wisdom shrugs off our individual emotional experiences.

The Hamas attack was deadly, and it will have profound implications. However, it does not look like the type of state-versus-state implications on trade from the Yom Kippur War in 1973 will materialize. Furthermore, the history of fighting in the Arab-Israeli conflict has typically been marked by short duration rather than the type of resource-intensive stalemate that is going on in Ukraine.

However, war and the deterioration of foreign relations raise prices; there’s often no way around it. So, if this issue expands and intensifies, it certainly could raise inflationary pressure, so I will keep a close eye on this risk as the events’ momentum becomes more apparent in the coming days and weeks. I’m assuming that despite the shock factor of the Hamas attack, the effect on markets will be broadly similar to other high-intensity periods in the Arab-Israeli Conflict during the 21st century.

While the relatively low-intensity conflict between Arabs and Palestinians slowly rumbles through time, it doesn’t have the same profound economic effects as when a conflict interrupts food production in one of the world’s largest grain producers. So, I think as devastating and sickening as these attacks were, the ultimate effect on global commerce will be much less than Russia’s Invasion of Ukraine.

Indeed, the market has sent two overwhelmingly bullish messages in less than a week.

1. Last Friday, a robust jobs report came in about double the consensus expectations. Markets reacted with an initial Treasury and equity sell-off that reversed into a massive rally by the end of Friday.
2. Today, markets initially responded by selling off to the unprecedented and cowardly attacks in Israel. Yet again, after a significant risk-off catalyst, the market reversed and rallied.

Anecdotally, when markets rally on bad news, I’m typically heartily encouraged. I have found this indicative of turning points in the post-COVID markets. These two events alone make me very bullish on the disposition of the market into year-end, but there are five significant reasons why I will be shorting volatility into the end of the year.

4 Reasons Why I Think The VIX Collapses Into Year-End

I have written extensively before on why I believe structural factors and increasing market efficiency have led to the VIX being a somewhat obsolete instrument for catching volatility and why many who expect spikes of levels similar to those seen in COVID-19 and the Global Financial will likely be continually disappointed. This is the primary reason why many investors have been fretting about a suppressed VIX. To sum up a key conclusion of my prior work:

So what seems like a paradox of more risk, lower VIX actually makes perfect sense given the relatively blunt and inconsistent nature of using the VIX as a practical hedge and the added stakes of hedging correctly. The bluntness is only exacerbated by the necessary limitation of upside created by market circuit breakers, which historical observations now suggest are successful in their aim to reduce the exact cascading sell-offs that result in the largest upside for the fear index.

Of course, a crucial distinction must be made when talking about why the VIX has been suppressed. In my past two articles on the VIX, I mainly focused on the structural reasons why volatility was relatively more suppressed while navigating an ominous group of post-COVID-19 risks than in previous periods when the market faced similar risks.

You can see this at play during the recent VIX spike on interest rate fears and volatility that appeared to peak last week. The VIX briefly got above $20, but I think it will continue to retreat into year-end, given several factors. While I am still convinced the structural and market efficiency factors contribute to a more suppressed VIX, I think many factors that will work with them to contribute to a suppressed VIX for the rest of the year are also fundamental and seasonal. Here are four reasons why I think the VIX will remain suppressed until the end of 2023.

1. The soft landing thesis appears intact. The jobs market is proliferating, but these aren’t high-paying jobs that drive inflationary spending. Furthermore, upward wage pressure has come down, meaning the job market strength is not exacerbating inflation. The economic strength will likely lead to strength in Q3 earnings. One positive sign is that companies are issuing guidance at the highest clip in five years, and all else being equal, more visibility means less price volatility, particularly during earnings season.

We often have a unique combination of robust economic data and consumer sentiment already at recessionary levels. Recessions are usually preceded by exuberance and confidence, not the perpetual fear and anxiety that leads to more conservative and rational economic decision-making in many cases. In other words, if you cut costs in anticipation of a recession, but demand stays the same or increases, you have likely just increased your margins. This appears to be going on widely in the US economy.

2. The Q3 Earnings season is upon us. When markets enter an earnings season, the focus tends to shift from macro drivers and the Fed to the earnings report of respective companies. And believe it or not, despite all the hollering and moaning from bears about term premiums, earnings estimates have ticked back up after declining in a wave of pessimistic sentiment earlier in the year. But, particularly after recent data showing better than forecast economic strength, I’m VERY optimistic about the upcoming earnings season.

But there is another underappreciated factor in how earnings season affects the VIX, even if it is a highly volatile one. The VIX measures volatility at the index level. Still, during an earnings season, volatility is actually suppressed at the index level as it increases at the level of individual stocks, so long as an all-correlations-go-to-one sell-off does not occur. In other words, the fact that we are entering an earnings season in itself means that the VIX should naturally be suppressed.

3. Seasonal factors have flipped mainly from negative to positive. The remainder of the year tends to see gains for the stock market. Little factors like a slight bump from late tax returns should prove a countervailing force on the weakening bottom four quartiles of US consumers. Yet, the top quintile unlimited purse is somewhat of a countercyclical buoy. Furthermore, standard seasonal factors generally converge to produce good gains in the Fourth Quarter.

In addition to the regular monthly seasonal strength, another minor feather in the bullish cap is that this seasonality is augmented in odd years versus even years. So, many positive seasonal factors should converge in the market’s favor. There is always the possibility that abnormal events derail the seasonal trends, but historical data is better than none in most instances.

4. The macroeconomic impact of the Arab-Israeli conflict, particularly in the wake of the Yom Kippur War, was multiplied by two factors: The Cold War magnifying and intensifying the consequences of the conflict and the developed world’s dependence on foreign-produced oil. Both of these items have changed. The world, despite apparent setbacks to globalization. The first significant change is that the US economy has become far less reliant on oil and is far more efficient in its use than when the Arab-Oil Embargo roiled global markets and the US economy in particular.

The other significant change is that the US is now one of the world’s largest energy producers. We consume a lot of our oil, and even though the current administration has made some missteps on the Strategic Petroleum Reserve, America’s energy dominance means that any interruption in oil markets will affect our economy less. US Energy exports hit a record in 2022.

It will also affect the global economy less. While the energy sector has been a polarizing political issue, if push came to shove and the United States faced economic ruin or dramatically increasing production, it would likely choose the latter. This is a different dynamic in the global economy than when Arab-Israeli issues badly affected prices and caused recession through energy shocks. Thus, one of the primary mechanisms through which volatility could affect markets is mitigated, and I think energy prices will ultimately be more affected by Chinese economic weakness.

The other reasons why I have expressed VIX suppression are all still intact, and I think those more secular reasons will converge with the seasonal to produce a low fear index for the remainder of the year. The most significant factor driving the suppression of the VIX is a matter of simple supply and demand. There has been a mass proliferation of more precise and even liquid alternatives to hedge against tail risk or single-stock risks.

Risks And Where I Could Be Wrong: Shake Your Tail Feather

“No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.”

– John Stuart Mill

Shorting the VIX or telling people not to hedge against risk is never a low-risk thing. Good thing that is not what I am doing. I want to clarify: the crux of my theory for VIX suppression is the changing nature of the market and the rapid proliferation of substitute products (or better fits in many cases), but this doesn’t mean you shouldn’t hedge against risk.

I think you should use more precise tools that will give you more upside. For instance, the Limit Up, Limit Down (“LULD”) rules for individual stocks will give you more upside than the market-wide circuit-breaker rules. These rules have effectively diminished the kurtosis of the VIX or chopped off the tail colloquially.

Still, despite these structural factors, there is a massive demand for VIX calls, implying that quite a few market participants disagree with my take. Many risks could get worse than markets already know about. I would include this as a comprehensive but not exhaustive list of the known risks currently stalking the market.

• Escalation of Geopolitical risks in China, Ukraine, or the Middle East.
• Fed Policy Error.
• Banking Crisis Worsens.
• Return of Inflation.
• CRE meltdown.
• Write-downs of Private Assets.

I would also point out that my assumption of declining volatility into the end of the year largely rests upon an economic soft-landing coming to fruition. If economic activity declines rapidly or the lag effects of monetary policy cause a significant credit event, then the VIX will spike and make this article look spectacularly wrong. Nonetheless, I think this is a low-probability outcome.

Conclusion

The reason you want to buy VIX options instead of just using put options on your SPX position is because the VIX has more convexity. The underlying is the implied volatility of the S&P 500, not a security, and implied volatility can spike quickly in a way that usually outpaces asset price moves. But the post-COVID markets have been of a different character than usual. The Fed has guarded financial stability more than consensus thought possible, and the US consumer has proven remarkably resilient. Now that seasonal factors are favorable, I don’t think these realities will turn around on a dime. The VIX also tends to decrease after inversion and briefly inverted on recent rate fears.

Of course, the main risk of shorting the VIX is getting blown out of the water by an unknown risk. The Black Swan risks we can’t know, anticipate, or sometimes even imagine will always be one of the most significant risks to shorting the VIX. People often equate it to picking up pennies in front of a steam roller. But in addition to seasonal factors being on your side, shorting the VIX in the wake of inversions has an excellent track record.

Still, if you think about the physical limitations of this metaphorical task, it is quite doable, just like shorting the VIX. However, I think the data is mainly sending the all-clear, and survey and sentiment data show that people are in a frightful Halloween spirit. This is a perfect condition for shorting the VIX, in my estimation.

They say markets climb a wall of worry and fall on a slope of hope. When the inflation report came in white hot and Hamas attacked unprecedentedly, markets sold off. But then they climbed the wall of worry and closed the days higher. While two anecdotal market occurrences don’t make a trend, I think they hint at how markets will respond into year-end, aided by seasonal factors. They will climb a wall of worry, and the VIX will likely remain suppressed. I am betting the recent spike just north of $20 was a local high until the end of the year.

So, let’s finish on ways to implement a short VIX. There are a few options I will provide for folks with different skill levels, risk tolerances, and time horizons. I’ll also tell you which contracts I’ve used/will be using. One of the points I’ve made about VIX suppression involved the proliferation of more precise tools. One tool that is a pretty easy way to short the VIX is a popular short short-term VIX ETF offered by ProShares (SVXY).

There are a lot of risks involved with this ETF, and it won’t perform like the VIX, but if you’re not used to trading options, it is a good way to capitalize on a collapse of SPX Implied Volatility. It is a highly short-term instrument, and you should monitor it daily. Carefully consult the prospectus before using this tool, and really do your homework. Don’t use it if you don’t understand it!

My preferred way of shorting the VIX is through VIX options. I think you have a lot more control here with regard to theta decay and implied volatility. As I’ve mentioned, the proliferation of 0DTE options has increased the agility of investors and enables you to squeeze a lot of alpha out of short periods. So, for me, I’ll experiment with a trade comprising both short-term VIX options, only eight days out. These guys can really pop if you catch the proverbial wind right; of course, the rapid time decay can also quickly vaporize capital.

For this higher-risk leg of my trade, I purchased the VIX Oct 18, 2023 $16 puts. These options were very cheap, around the close at .25 cents. However, this part of the position is negligible compared to the October 18th puts. The theta decay is a double-edged sword because, of course, if it goes against you, your contract will quickly go to zero. But, on the other hand, you have a very pure exposure to price movement. This can serve its purpose, but it’s like flying a helicopter in a hurricane.

Thus, I like to balance my ultra-risky positions with little time to expiry with a longer-dated option that is near or at the money. For this particular trade, given the recent spike in fear and negative sentiment, I will purchase the VIX Dec 20 $16 puts and $17 puts. These last traded at $0.91 and $1.42, respectively. I will put tight stops on my riskier positions and looser ones with more time value. This way, I will prevent a total loss of capital if the VIX moves to higher levels.