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Time To Short The VIX?

Summary Historically, we haven’t reached breakout status for the VIX. Many global factors are at play. This is possibly an economic event leading to longer periods of backwardation. The last week in volatility has been very exciting to say the least. The VIX Index logged the highest ever one week gain in percentage terms. Again, we immediately had the pundits out yelling short the VIX. I saw posts on Thursday around the web urging readers to short the VIX. Someday, this will end poorly for them and the people that heed their advice (Friday should have been a good sign). Below we will examine whether this really is a good opportunity to short in terms of risk verses reward. I am always analyzing my risk and reward in a trade. Once the reward begins to outweigh the risk, then I will begin planning my entrance. I believe risk and reward are currently the same. Essentially giving you a 50/50 chance of profiting right now. More to come on that later. Let’s start by reviewing the past month for the Proshares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) and the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). You can clearly see the effect of last week in the chart. Similarly here is a chart showing the front-month VIX futures contract. As you know (or should know), UVXY does not track the VIX Index, which is currently at 28. This is a large divergence from the front month futures contract. Remember futures trade independent of the market and the VIX Index. This, in my opinion, means that investors aren’t that concerned yet over a crash in the markets. U.S. economics continue to be neutral to positive. However, global economic fears are beginning to spillover. Just six months ago analysts were touting emerging markets, now look at them. For more on how UVXY profited during the 2008 and 2011 VIX events, check my library here on Seeking Alpha. UVXY will benefit from the current levels of backwardation if they can hold for a longer period of time. See below: (click to enlarge) Backwardation at 6.5% roughly means that UVXY will increase 13% in one month’s time if futures stay the exact same price, minus any fund fees. Now we know futures never stay the same, but this is just an easier way to think about contango and backwardation. Backwardation hit over 20% in 2011 and over 40% in 2008 (backtested). Backwardation is the only way UVXY will hold profits over longer periods of time. Again, check my library for articles on backwardation if you are unfamiliar with the term. Historical Numbers I know many of you are very excited about this spike. However, let’s compare this event to past events. Backwardation: (click to enlarge) At 6.5%, this puts backwardation higher than a normal political event. If you remember in my last article we discussed the differences between an economic and political event. This event, so far, is leaning towards an economic event. Economic events are usually much more drawn out. I told you earlier in the year I was looking for a backwardation event higher than 10%. I believe this could become that event. More about this in the conclusion. Futures Levels Futures levels directly impact UVXY. Here is a longer-term chart of those futures levels: Yes, futures are towards the higher end of what they have been over the past three years. However, this is nowhere near breakout status. Futures generally trade lower than the VIX Index during a spike. For reference however, here is the VIX Index dating back to 1990: Conclusion The best entry points in the VIX futures, for shorting UVXY or going long XIV, occur during periods of prolonged economic turmoil. Yes, we logged the highest ever one week rise (by percentage) in the VIX Index. However, I feel we still have room to rise. Those pundits that are shouting short the VIX may be right or may be wrong, that is not the point of this article. I like a lot of reward for the risk I am taking. I don’t see the VIX returning to 12 anytime soon. We are in a prolonged period of slower economic growth. Eventually that was going to catch up to valuations and the U.S. stock market. We have recessions in Brazil and Chile. We have slowing growth in China, which should be your biggest concern. The Greek drama is off the table for now but you still have a case of many countries within the Euro that have very high debt levels and growth that isn’t high enough to sustain it. Here in the U.S. we also have unsustainable debt levels but can print however much money we desire. Ultra low rates have helped lower the burden of interest payments but the lack of decent inflation has backed The Fed into a corner in regards to raising rates. A September rate hike would spook the markets. The fact we don’t see higher inflation even given the ultra low interest rates is a realization and confirmation of the slow growth era. For now, I will remain on the sidelines and hope conditions continue to worsen. If I miss the opportunity, I am certainly okay with that. My total VIX portfolio is up a healthy amount YTD and I am fine with locking in those gains instead of gambling it away. This is not to say that I am not salivating at the mouth for a chance to short the VIX. Here is what I am currently watching, in order of importance: The Fed (what’s going to happen with rates, I view any delay as a negative confirmation on the U.S. economy) Economic data out of China (can the government stop the decline this time?) U.S. employment data (weekly) Devaluation of the Yuan (will it continue?) Economics in South America Political/debt situation in Europe (Greece drama is on the back burner for now) I am not backing up the truck to short this spike. We may get a bounce in the U.S. next week but economic problems always take a while to resolve themselves. I would short the VIX with caution if you feel that is the right thing to do. Call spreads (more info on my blog), stop losses, and not jumping all in help to limit your risk/reward. Risk management is needed here, otherwise you are just gambling. I wish you the best this week and know that I will be following the situation and posting updates when needed. It will be an interesting week! Should conditions deteriorate even more, I might begin shopping for a small position. With school starting, I would only be looking for a more long-term position since I am busy during the day. I just need more reward for the current level of risk. Donate to my classroom! I am trying to create a 360 degree mathematics classroom. Much of the money I make here on Seeking Alpha is donated back into public education, something I really believe in. My students come from the highest area of poverty where I live. They are truly great students with a desire to better themselves. My job is to level the playing field and give them a chance to succeed. One tool I used last year at a different school was a 360 degree mathematics classroom. It is a great tool for math teachers. A lot of what I teach lays the foundation for financial literacy and success in post-secondary education. Here is the link if you would like to help fund my 360 degree boards. Use the code SPARK at checkout (until 8/27) and your donation will be matched 100% up to $100. Currently they are running another promotion from The Gates Foundation that will also match 100% up to $1,000 (which would be more than what is needed). That code is JUMPSTART but will only be available for a limited time. You can’t use both codes. All donations are tax deductible and will make an actual difference in the education of some great kids. We are getting close to funding. Thank you! Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in UVXY over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

How To Invest As Fear Is Thrown Into The Market

Summary As fear increases in the market, volatility has rapidly risen in one of the shortest timeframes on record. Traders betting on a normalization of expectations should position for an eventual decline in volatility. Investing alongside the impact of contango results in the best returns. Investments never consistently trade in a single direction forever. Over the past week, the crash of major stock indices has been a stark reminder that surprises to investors can happen very quickly and that fear itself can often prove to be a powerful force to be reckoned with. Yet potential opportunities exist in every situation. One such trade to now consider is the eventual suppression of uncertainty as the stock market once again normalizes and regains its composure. Over the last few days, volatility has very rapidly been increasing as a result of this uncertainty. This can be seen in the graph of the Volatility S&P 500 Index (VIX) found below as compared against the S&P 500 represented by the SPDR S&P 500 Trust ETF ( SPY ) . The VIX is quoted in percentage points and roughly equates to the expected movement in the S&P 500 index over the subsequent 30-day period when annualized. The index is a largely constructed by utilizing the implied volatilities of a wide range of S&P 500 index options. In general, the VIX represents the expected swing of the market in either direction as an expressed percentage over a given period of time. Since trading at a low of $13 on Monday, August 17, the Volatility S&P 500 Index soared to a closing price of $28 on August 21. This is greater than a 100% rise over the course of days, and therefore represents one of the most sudden movements recorded in the index’s history. It also reflects the high degree of uncertainty in the market as investors scrambled to buy options in order to gain protection for their investments. Yet as it often tends to be the case, fear and uncertainty naturally subside over a given course of time. Historically, this too can often unfold in a very rapid manner. As noted in the graph below, the VIX frequently spikes only to rapidly return back to a more sustained level in the mid-teen price range. Reasonably, this allows for a trader to predict and to invest into the normalization of market uncertainty by positioning for the eventual decline in the VIX. While investors can directly invest into the VIX through the utilization of call and put options, those unfamiliar with the use of these trading tools can still capitalize upon this predictable trend. One such investment method is to consider a short position in a related fund that is correlated to the VIX. For example, the iPath S&P 500 VIX Short-Term Futures ETN ( VXX ) is an exchange traded note that offers exposure to the daily rolling long position in the first and second month VIX futures contract. Yet as a consequence of contango, the VXX is almost inherently designed to decline in value. Contango occurs due to the perishable value of the premium attached to futures prices set before the expected delivery date. As a consequence of contango and the reliable trading action of the VIX itself, the long-term trend of the VXX is made abundantly clear in the graph shown below. Over the long-term, contango and the lack of a consistently fearful market typically dictate the downward trend of the investment. As seen in the graph below, such a trend has been well defined for many years. (click to enlarge) However, not everyone is capable of entering into a short position. There is also an inherent danger as the potential losses of a trend that backlashes against expectations are theoretically limitless. Therefore, investors could alternatively go long a VIX inverse investment such as the VelocityShares Daily Inverse VIX Short-Term ETN ( XIV ) in order to capture a similar trend. This investment seeks the inverse performance of the S&P 500 VIX Short-Term Futures Index. For those wanting to limit the volatile nature of the this long position, one can also consider the VelocityShares Daily Inverse VIX Medium-Term ETN ( ZIV ) . This investment seeks the inverse performance of the S&P 500 VIX Mid-Term Futures index. The difference between these two futures indices is that the short-term index utilizes the prices of the next two near-term futures contracts whereas the mid-term index utilizes the prices of the fourth, fifth, sixth, and seventh month future contracts. As a result of this, the mid-term index faces significantly less volatility and a reduced impact from contango. The resulting trends of each of these investments can be found in the comparison graph below. While both XIV and ZIV have historically trended higher, it is clear that traders seeking higher returns are more prone to invest into XIV following a deterioration of the upward trend, which occurs when increased fear returns to the market. Final Thoughts It is important to remember no one is capable of predicting the future with perfect accuracy. As such, both traders and investors should often consider utilizing multiple entry points in order to average down into a comfortable position. Just because fear and volatility have risen to a very high point in a limited amount of time, there is no reason to believe that it will not be able to continue to rise in the days and potential weeks to follow. Nevertheless, for the patient investor capable of identifying opportunity when it passes by, the potential return from a predictable trend found in volatility can often be quite rewarding. After all, the odds of a market that continues to consistently become ever more fearful is rather slim statistically. Disclosure: I am/we are long XIV, ZIV. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

MLP Screening – Did The Market Overreact To Some 10%+ Yielding MLPs And Should We Value Them Differently?

Summary MLPs have held up relatively well against the commodity price decline until it recently plunged ~20% in the last 3 months. Alerian MLP ETF currently yields 8.5% with a select number of names trading well above 10% distribution yield. MLPs have largely been safe yield vehicles – will there be a shift in investor base and change in how investors value MLPs? Disclaimer: For avoidance of doubt, any reference to MLP excludes E&P MLPs for the purpose of this article. Alerian MLP Index (AMZ) Price Performance (click to enlarge) Alerian MLP Index Yield vs. Other Indices (click to enlarge) MLPs have been an efficient route for midstream asset owners to monetize their stake in assets that have largely contracted or recurring cash flow characteristics at valuations that far exceed private transaction multiples. For investors, it has been a very attractive/safe yield vehicle (and tax friendly) underpinned by a consistent and high growth profile as billions of new capital got deployed for new drilling and infrastructure developments. At a very high level, most MLPs service the upstream and/or downstream value chain in providing long-term recurring services. A recurring revenue stream ensures stable cash flow and given that 90% of distributable cash flows are required to be distributed in order to maintain MLP classification, investors enjoyed stable cash yield. Continued expansion of infrastructure and oil & gas exploration activities also led to high-single digit to double-digit growth in distribution. As a result, distribution yield (with growth embedded) kept falling and valuations kept going up. MLPs were also able to grow through acquisitions, using its extremely cheap cost of capital to acquire businesses at high multiples, which were still accretive from a distributable cash flow (“DCF”) point of view. While investors can view MLP businesses using more traditional valuation metrics such as EV/EBITDA and P/E, in real life, and in a grossly oversimplified form, valuations are quoted based on distribution yield. Again, in a very simplified manner, if you were to dissect distribution yield, the market essentially assigns a cost of equity (what level of levered cash flow the business should generate in perpetuity) and subtracts a growth rate on the DCF – and this dictates the distribution yield that the market bases its valuation/stock pricing for that particular MLP company. Let’s dig a little deeper in terms of this valuation concept. This was a perfectly feasible method of valuation for a number of reasons. 1) DCF for an MLP is actually very predictable and stable (EBITDA – maintenance CapEx – interest expense was very stable), 2) because it is very predictable and MLPs are required to distribute that DCF to investors, it made even more sense to value the business from a DCF/distribution perspective, 3) growth through backlog and continued capital spend in the broader oil & gas industry was also very visible and the implied valuation derived from a yield (or multiples if you invert the yield) standpoint was far in excess of general market valuation, and therefore, using EV/EBITDA or P/E where the general market trades at ~9-10x EBITDA and ~16-18x earnings obviates any sense of comparability. Said in a different way, DCF growth rate is what moved the needle from a valuation standpoint and was therefore the most important variable in determining how the stock price would move. To avoid any psychological biases, let’s remove the “MLP” classification for a second and just consider them as a normal c-corp business. Also, let’s work under the premise that there is no debate around the fact that the commodity price environment is challenging and there are lots of uncertainties and macro headwind pervading the market. For simplicity, let’s take out the near-term growth component and say there is no growth for the next year or two. Even without growth prospects, these are excellent businesses with contracted/recurring cash flows, minimal capital requirement to maintain earnings power, and minimal operational complications (often times there are pricing protection through contracts and even annual CPI escalators). How much would you pay for this type of business? Maybe there will be a slight dent in EBITDA this year or next year (not many names are really taking a hit on cash flow, they are just growing at a slower rate), but if the premise is that there is always cyclicality in the commodity market and things will turnaround to get back into a nice growth trajectory in a year or two from now, how much would you pay off next year or two-year forward FCF? To take a more draconian stance, even if there was no growth trajectory in a year or two from now, is it truly justifiable to say that many of these businesses should trade at 500-1000bps above debt instruments with equivalent credit ratings? When was the last time you were able to pick up a stock for 4-9x levered free cash flow even if there was a dim outlook for businesses that possess this quality? For the purpose of identifying “better” quality – off the top of my head, few high level components to look for in terms of evaluating the fundamentals of these businesses: 1) Contract structure (duration, minimum volume commitment, take-or-pay % vs. throughput %, fixed fee vs. commodity price dependent fee, inflation escalator); 2) Customer credit (liquidity, credit ratings, leverage), types of customers (E&P, refinery, other midstream, logistics, export demand, etc), customer diversity (having customer concentration through an excellent customer may sometimes be more favorable than having mediocre quality diversified customer base); 3) Liquidity (cash + RCF availability); 4) Geography (if volumes are growing at a certain geography or basin, it doesn’t matter if commodity prices are falling for the midstream provider); 5) Maintenance capital as % of EBITDA; 6) Growth capital need and payback period (some businesses like a pipeline are capital intensive in the beginning but it’s all about maintaining existing volume and increasing utilization whereas some businesses require continued capital spend to service both existing and additional customers; it’s a tough dynamic if you are in a spot today where you are asked to spend capital in hopes that you will utilize them in the future) While there was always some level of premium/discount for MLPs depending on sub-sector, commodity price exposure, contractual structure, maintenance/growth capital need to maintain cash flow profile, geographic footprint and size consideration, today’s market where many players are trading at yields that imply distribution cut and at a meaningfully compressed valuation relative to few months ago and versus the broader market, it definitely seems like an interesting environment where MLPs are interesting not just as a safe haven and perpetual dividend asset but an opportunity to generate alpha through capital appreciation. During this oil crash since summer of 2014, you have consistently seen sub-sectors get crushed, only to see a lagged pick up among “better quality” names (E&P, OFS, LNG, Petchems, etc). This sequence of overreaction immediately followed by a quick and steep rebound among quality names is common across all sectors during a market sell-off. While this article does not address a specific recommendation and may be repeating what is already well recognized among investors, I wanted to provide 1) a quick screening of MLP names that are under oversold categories and 2) perhaps a different perspective around decoupling from the prevalent methodology of looking at MLPs like a fixed income security to a more traditional equity security (especially in light of what the valuations imply at today’s price and for those who think investing in MLPs today is like catching a falling knife). Below is a quick screening based on MLPs trading above 10% 2015E distribution yield (I am sure I am missing a few names that have above 10% yields). Second table excludes names with net debt/’15E EBITDA above 5x. There is not much science for drawing the line at 5x but wanted to exclude names that may be trading at compressed valuations due to distress and/or were previously highly levered to rapid growth prospects. Again, I have no idea if the excluded names are truly in distress or sized debt prematurely with too much embedded growth – just wanted to make the bifurcation. MLP Universe (NYSEARCA: AMLP ) – Names trading above 10% distribution yield Source: Capital IQ – Crestwood Midstream (NYSE: CMLP ), Crestwood Equity (NYSE: CEQP ), Southcross Energy (NYSE: SXE ), Azure Midstream (NYSE: AZUR ), Hi-Crush (NYSE: HCLP ), Natural Resource Partners (NYSE: NRP ), CSI Compressco (NASDAQ: CCLP ), Cypress Energy (NYSE: CELP ), American Midstream (NYSE: AMID ), Teekay Offshore (NYSE: TOO ), Capital Product Partners (NASDAQ: CPLP ), Midcoast Energy (NYSE: MEP ), Martin Midstream (NASDAQ: MMLP ), Exterran Partners (NASDAQ: EXLP ), Targa Resources (NYSE: NGLS ), DCP Midstream (NYSE: DPM ), USA Compression (NYSE: USAC ), Teekay LNG (NYSE: TGP ), NGL Energy (NYSE: NGL ), Oneok Partners (NYSE: OKS ), Suburban Propane (NYSE: SPH ). MLP Universe – Names trading above 10% distribution yield and less than 5.0x net debt / ’15E EBITDA Source: Capital IQ – Crestwood Midstream, Crestwood Equity, Azure Midstream, Hi-Crush , CSI Compressco, Cypress Energy, Teekay Offshore, Capital Product Partners, Martin Midstream, Exterran Partners, Targa Resources, DCP Midstream, Oneok Partner , Suburban Propane. Disclosure: I am/we are long CELP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.