Signal du Jour - short vol in UVXY

Who saw the black swan?

A new quarter is about to start, and while this week will be interesting from a rebalancing perspective, all eyes are already fixed on the first week of July. Summer officially began over the weekend, and the traditional American holiday is just a few days away. What can we expect from that? Fewer people at their desks, lower volumes, and lower volatility. Or at least that’s what we all hope for. Who wants their holidays ruined by a good old black swan? Certainly not us.

That being said, because of the shorter week, we're exploring a trade that our readership should now be comfortable with: short volatility in UVXY.

Yes, we know that stuff can blow up and eventually will one day. We're far from oblivious to the risk. However, one can’t reasonably chase performance without considering this trade as a regular tool in their arsenal.

Let’s have a look.

The context

At the beginning of the year, there were two camps: those predicting a highly volatile first half, claiming the Fed’s battle with inflation was far from over, the AI bubble would soon burst, and the economy was headed for a hard landing. The other camp put forward an equally sensationalist argument: nothing significant would happen this year because it is an election year.

We were skeptical, but so far, they are winning the foresight game. Realized volatility has been extremely low, to the point where, except for a brief spell in April, you could have simply sold volatility in 2024 and done nothing else. (Except buying stocks, of course).

3 distinct volatility regimes - prior 2022 and after May 2023.

Since March last year, the 30-day realized volatility in the SP500 has barely crossed 15 twice: in October 2023, right before the Fed announced they were done hiking rates, and in April, when Israel and Iran clashed.

What is even more striking about this chart is the absence of volatility. 2021 was also a calmer year, with a fair amount of time spent between 10 and 15. The difference was that the swings were much more pronounced than what we have observed so far this year.

And what is UVXY exactly? It is an ETF that gives investors exposure to the ebbs and flows of the VIX, which, in turn, gives them exposure to implied volatility. It is not exactly a one-to-one relationship, but still. So when you are trying to sell volatility, considering a straddle on UVXY, VXX, and others is often a good place to start. Now the comparison stops here, and let’s see what the realized volatility in UVXY has looked like so far in 2024.

Nothing critical has been happening in UVXY, except the short spell in April 2024.

Since the peak observed in April this year, the volatility in UVXY has been crushed, and we are now at the lowest levels observed over the past few years. Yes, it can indeed go back up fairly quickly, and we bank on that to assume that the prices of straddles are overstating what is currently happening in the underlying.

Let’s see what the data are saying.

The Data and the Trade Methodology

Let’s start by looking at a reconstruction of the VIX 30 days using options data in UVXY.