Awesome Stock Market Indicator - Cash VIX Term Structure

Video Transcript:

(0:00 - 3:55)

Welcome back everybody to Volatility Trading Strategies. So this latest stock market crash due to the health crisis, we can't actually use the word here on YouTube so we'll just say health crisis, but the market has continued to sell off. From the all-time high set on February 19th to today March 20th, in one month the S&P 500 has crashed down minus 32 percent.

This is easily the largest drop since the financial crisis. Here's all the maximum drawdowns for the various market crashes since 2008, and these are all on a close to close basis for the S&P 500. We got the flash crash in 2010, the European debt crisis in 2011, we'll call it the China hard landing scare in 2015, volpocalypse in 2018, and another in Q4 2018.

So this crash of minus 32 percent is far more severe than any of those other ones, and we're more than halfway now to the minus 57 percent the market crashed in the financial crisis. Now I'm not trying to scare anybody, I don't think that's productive, but hopefully people who've been watching my videos over the last several years have found a way to rotate to safety positions like I always talk about, because anybody can make money when the markets go up, but avoiding big drawdowns, that is the most important part of the equation. Don't let anybody ever tell you different.

Big market gains are nice, and they do serve as good pieces of marketing material for the financial industry when markets cooperate. Of course 2019 was full of advisors talking about their great performance, but minimizing those bear market losses on the other side of that coin is even more important. Now if you're interested in seeing how the VTS community navigated this period, there is a free trial on my website, and of course you're always welcome to pop in and see if it suits your long-term investing goals.

So in my previous part one video a few days ago, I talked about how traders can use the VIX futures term structure to try to get an idea for when the selling might be over. Today I want to continue that conversation, and I'm going to show you another interesting way that traders can gauge the pulse of the market. I call it the Cash VIX Term Structure.

So subscribe to the channel, and you have to hit that little notification bell next to it. YouTube isn't great about letting people know when there's new videos, so go ahead and hit that bell, and let's talk about the Cash VIX Term Structure. So first I'll explain what the Cash VIX Term Structure actually is.

Now we talk about this all the time in the VTS community, but I very rarely see mention of it anywhere else, so you might not actually be familiar with it. And then I'll show you how it can be used to gauge the pulse of market participants, and perhaps be used as a signal to gauge when the crash might be over. This is a screenshot from my daily blog on January 16, 2020, two months ago.

For one of those points on the curve you may already be quite familiar with it, and that is the VIX index. Remember the VIX index is calculated based on a strip of S&P 500 options, and it's a 30-day forward expectation of market volatility. I have a full video explaining what the VIX index is, so you can check that out later.

But what many people don't know is there are other indexes that are calculated using the same methodology as the VIX index, just over different time periods. The first one there is the VIX9D. Again, it uses the same methodology as the 30-day VIX index, it's just a 9-day expectation of volatility instead.

That's why I've placed it on the left there, the shortest duration. Then the VIX index, which most people know about at 30 days, and to the right of that is the VIX3M. This is a forward 3-month look at volatility.

Further out still is the VIX6M, which as the letter suggests is a 6-month forward volatility calculation. And lastly, the furthest out index is the VIX1Y, a full 1-year forward volatility calculation. So when we plot all these indexes on a curve, I call this the Cash VIX Term Structure.

The word cash is because none of these indexes are tradable. Just like the VIX index, all of these are just statistical calculations, you can't actually buy or sell them. Now just a heads up here, because it's a fairly popular free stock charting software, but as of making this video, StockCharts.com still hasn't updated their database for the correct ticker symbols.

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These were changed ages ago, but StockCharts still uses the old tickers for some reason. And maybe your software does as well. The current VIX9D used to be called VXST, VIX3M used to be VXV, and VIX6M used to be the VXMT.

So try those if you're having trouble finding the real tickers. But this Cash VIX Term Structure from January 16, 2020, two months ago, is an example of a completely healthy and normal curve. In fact, I even posted this on Twitter a few months ago.

(4:22 - 4:56)
At the risk of sounding like a weirdo, that's the most beautiful Cash VIX Term Structure I've seen in quite some time. Now when you're done watching this video, head over to Twitter and give me a quick follow. I do post up-to-date volatility metrics quite often there.

@VolatilityVIX is my handle. But my joking innuendo aside, this is what we see in stable bull market periods. You can see that it's upward sloping to the right.

Each further out in time volatility calculation is higher than the previous one. The 9-day VIX9D is the lowest, then the 30-day VIX, then the 3-month, 6-month, and 1-year. Totally normal and clearly representing a stable market.

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This is the S&P 500 for 2020, and right there, that's January 16, which did have that beautiful Cash VIX Term Structure. No surprise, stocks were stable and just marching higher at that point. That January curve is a perfect illustration of the volatility risk premium.

Remember the future is always uncertain. We don't know what's going to happen tomorrow, next month, or next year. And the further out in time, the more bad things can happen.

So traders need to be compensated for taking on that additional risk further out in time. In a stable market, we expect to see the higher volatility pricing further out in time. That's completely normal.

Except during times of elevated fear. This is the Cash VIX Term Structure from my daily blog on February 28, 2020. So the first one from mid-January was perfectly healthy, upward sloping.

This one though is the complete opposite. It's downward sloping. Notice how we have the shortest 9-day duration VIX9D at the highest level.

And then each further out date is lower than the previous one. 3-month is lower than the 1-month VIX. 6-month is lower than the 3-month VIX3M.

(5:56 - 8:18)
This is a Cash VIX Term Structure in an obvious period of heightened fear. Of course, right? Stocks had already begun their collapse at this point. Now another thing I do for the VTS community and every daily blog is, I do calculate the ratios of each of the individual periods and put those on the chart as well.

Because traders with different time frames are going to want to focus on different points on this curve. Short-term traders may be more interested in the front end of this curve, the VIX9D to VIX ratio. Whereas longer-term investors may focus more on the VIX3M to VIX or the VIX6M to VIX ratios.

That V stands for the actual absolute value. So for example, 1.3979, that's the ratio of the VIX9D over the VIX index, nearly 40% higher. The PR stands for percentile rank and shows where the current value is today compared to all previous values back to inception.

So 99.9%, clearly on February 28th, 2020, the VIX9D to VIX ratio was about as high as it's ever been in history. That curve for the Cash VIX Term Structure may appear simple, but there's a wealth of information in there. The slope of the curve, the different time frames, the ratios between each of those sections, where they all rank in historical terms, all the information a trader needs is in there.

So if this is a perfect Cash VIX Term Structure curve on January 16th, which was a very stable stock market period with consistent gains, and this is a completely inverted and ugly curve on February 28th, an obvious period of elevated fear and uncertainty, and the crash was well underway at this point, then couldn't investors use this to identify periods where fear and uncertainty may be escalating? The stock market made its last all-time high on February 19th, 2020, right there. And this is what the Cash VIX Term Structure looked like on that day. My three main tactical ETF rotation strategies all moved to safety positions by February 21st, which is right there, avoiding the carnage that was coming.

Out of stocks and into bonds in our core strategy, out of the S&P 500 and into 30-year treasuries in the VB threshold, and we were already out of our short volatility positions and in cash as of a couple days before in the volatility strategy. Now full disclosure, I look at dozens of volatility metrics to guide my trade decisions. Investing is tough and we need a comprehensive analysis in order to navigate these unruly markets safely.

But the Cash VIX Term Structure is definitely one that I'm always keeping an eye on. It's one of my favorite indicators and it's posted in my blogs every day for very good reason. February 19th, the all-time high in the S&P 500 in a completely normal curve.

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Notice the VIX9D to VIX ratio is within the 6th percentile of all previous values, clearly very stable right here. February 20th, still looking okay, but the front end ratio has started moving up to the 14th percentile. February 21st, for me this was a real warning that the market may be heading for trouble.

VIX9D to VIX ratio in the 64th percentile and the whole curve getting pretty flat. This is where we moved all our strategies to safety. February 24th, now we're in full-blown decline mode, full inverted curve and all the ratios in the high 90s percentiles.

And by February 25th, this is about as ugly as things get and it's just continued every day since then. There's many indicators that I use to navigate these markets. The VIX futures term structure from the part one video, the Cash VIX Term Structure from this video, and dozens more.

So the question on everyone's mind is, how do we know when the crash is over? Well, my entire investing philosophy is based on the answer that I don't know. And no offense, but neither do you. Personal market predictions are unreliable.

For every time that we guess correctly, there's going to be a time that we just get it dead wrong. That's why I always like to rely on quantifiable volatility metrics to guide my trading decisions. Actual numbers that have no emotion attached.

It's just math and they can correctly gauge the market without my own gut instincts. So eventually, the Cash VIX Term Structure will normalize. That's just a matter of time.

We will see the front end VIX9D to VIX ratio dip back below that 50th percentile and head towards the low again. Until that happens though, until we see significant healing in the volatility complex, I for one will remain in safety. I may do some bottom fishing in my dedicated options trading portfolio, that's vtsoptions.com, but just please be careful out there.

The volatility metrics that I track and put in my daily blog every day that did pick up on those warning signs, they still haven't stopped flashing full on red. So definitely put an extra focus on risk management if you are going to attempt to trade this market. Keep allocations small and remember you don't have to swing at every pitch.

Above all else though, stay safe, stay healthy, abide by the quarantine, and take care of the people around you. At some point this will pass. So if you like this kind of volatility analysis and you want to see dozens more of metrics just like this, go claim your free trial on my website to join the VTS community.

You're always welcome. See you next time. Thank you so much for watching the video.

So don't forget to subscribe to the channel and go check out my website right here. There's tons of articles and videos on there, as well as a free trial to join the VTS investing community. What have you got to lose? Come see how I personally navigate these unruly markets.

See you next time.