It is one of the most frustrating puzzles for market participants — and it is happening right now. Stocks feel sluggish, choppy, and unable to make decisive upside progress. Even more significantly, many market leaders are gyrating in price regularly.
Here's the Invesco QQQ Trust (QQQ) over the past two months. While the market's main fear gauge, the CBOE Volatility Index ($VIX) is tied to the S&P 500 Index ($SPX), QQQ and SPY are more in sync now than ever. So this level of volatility in QQQ should translate to the VIX, at least a little.
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That's my take. But the market is not behaving that way. Not at all. What's up with that?
The VIX keeps grinding steadily lower. Common sense suggests that if the market is stuck or feeling vulnerable, volatility should at least hold flat or creep higher. Instead, VIX continues to melt away.
Understanding this disconnect requires looking under the hood at how the VIX is calculated and why holding volatility ETFs like the ProShares VIX Short-Term Futures ETF (VIXY) or the ProShares VIX Mid-Term Futures ETF (VIXM) during range-bound market regimes can be financially punishing. I say that from recent personal experience!
Here's VIXY, which tracks the next month's volatility. It's been a one-way ticket to Hades since April.
Next, here's VIXM, which tracks VIX using futures contracts that go out a few months. That smooths the ride in terms of how the exchange-traded fund (ETF) trades. But it doesn't change the pattern. It, too, has been consistently southbound, now priced near a two-year low.
Why Volatility Crumbles in a Sluggish Market
The fundamental mistake many traders and investors make is treating the VIX as a simple "anti-stock market" gauge that rises whenever stocks look weak. In reality, the VIX is a mathematical calculation derived from S&P 500 index option prices. It measures the market's expectation of price movement (speed and magnitude) over the next 30 days. So when stock indexes trade in a tight, range-bound consolidation, two key forces suppress the VIX.
One is the explosion of income-seeking strategies, such as covered-call ETFs and zero-days-to-expiration options. When professional managers continuously sell options to collect yield, they artificially depress option premiums across the board, driving implied volatility lower. I see it more and more every day, as I do my own option scouting.
Compounding this, if the S&P 500 or Nasdaq 100 (NMU26) fluctuates by mere fractions of a percent day after day, institutional portfolio managers refuse to pay inflated prices for downside put protection. As demand for portfolio insurance dries up, options pricing collapses, pulling spot VIX down with it. QQQ has been more volatile than SPY, and the recent past has been more of a quick back-and-forth, rather than 10%-plus swings in either direction. Not a whipsaw, but a continued series of fake-out breakouts and potential corrections that are quickly snuffed out before they get out of hand.
You cannot buy spot VIX directly. Instead, ETFs must hold VIX futures contracts, which introduces the hidden tax known as contango. In a calm or sluggish market, long-term VIX futures trade at a higher price than the spot VIX index. This upward-sloping futures curve creates a persistent headwind for ETFs. That negative roll yield creates the capital bleed we've been seeing.
Holding VIXY in a sideways market is like watching a slow leak drain a tire, another situation I've experienced personally in the recent past. In this case, VIX may stay flat, but VIXY and VIXM lose money over time. Now, they can snap back to life in a heartbeat. But from what level? That is the question.
Sluggish stock markets do not automatically create rising volatility. In fact, prolonged range-bound trading usually crushes option prices, driving VIX lower while burning buyers of short-term volatility products, like me.
The Bottom Line
What can traders do about this? Inverse ETFs are one solid consideration. For betting against SPY, the Short S&P500 -1X ETF (SH) is a personal favorite. The Short QQQ -1X ETF (PSQ) runs counter to QQQ, and the mirror image of the Russell 2000 iShares ETF (IWM) is the Short Russell 2000 -1X ETF (RWM).
However, I find a cleaner substitute for those VIX-driven ETFs can be leveraged inverse ETFs, such as the Ultrashort S&P500 -2X ETF (SDS), which moves twice the opposite of SPY daily, resetting each night. I say that because if one were using VIXY or VIXM, they are likely taking a very small position (or at least they should be), since they can be very volatile themselves.
In that context, a 2x or even a 3x inverse ETF like the Ultrapro Short S&P500 -3X ETF (SPXU), similarly in smaller size, is a consideration.
The VIX has been even more difficult to participate in for much of this year. But the math can work in one's favor too. We just need a market shock to stoke the fire.
Rob Isbitts is a semi-retired CIO, former fiduciary investment advisor, and Barchart columnist. Check out his other work at ETFYourself.com (featuring the Fresh Charts weekly trading post), and ROAR.PiTrade.com, helping investors to better-manage their own portfolios.
On the date of publication, Rob Isbitts did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com
