Tag Archives: seeking-alpha

Exiting A Short VIX Trade

Summary A common question I receive, answered here. An update on the contango and backwardation strategy. Current advice on the VIX. Hello everyone, I hope you have had a profitable month so far. A common question I receive revolves around when to exit a short VIX trade. There really isn’t a common answer to this question but I would be happy to share what I do. Before we begin our discussion I wanted to go over a few things. I believe volatility trading can be done by all different types of investors. I personally follow a very simple method and I know there are many others here that comment with more complex strategies. In reality they all follow the very basic principles of buy low and sell high or in the case of shorting volatility short high cover low. Once you have a good understanding of the basics in volatility, I encourage you to keep increasing your knowledge by reading higher level articles and studies to further your understanding of volatility products. Many times the final piece to understanding lies in the why. Once you can accurately explain why, then you have reached mastery. I have always focused more on the how to than the why. Next summer, I am making a goal to change that and will begin focusing more on the why then the how to. I have spent a great deal of time putting together educational pieces on volatility products and you can view all of those in my Seeking Alpha library. My articles have focused on the basic principles of volatility trading. I started writing to help beginner to moderate level traders who are interested in trading volatility products. When I started trading volatility, not many resources existed for the average investor. I will continuously link back to those pieces and try to promote investor education throughout this transition. One last thing, the comment sections of my articles are always my personal favorite. Even though I don’t respond to every comment, I do read them all and am continuously impressed by what I read. Some of you write such good comments that you should look into actually writing an article or two for Seeking Alpha. Just think about it. I think you would make great contributors. Exiting the short VIX trade A reader suggested strategy for entering a short position in the VIX is posted under this article on contango and backwardation . That article looks into the entry points for shorting the VIX. However, it leaves the exit point up in the air and only causes an exit trade once futures re-enter backwardation from contango. That really isn’t the best overall exit strategy. For the basis of today’s discussion we will use the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ). Another favorite short of mine is the Proshares Ultra VIX Short-Term Futures (NYSEARCA: UVXY ). VXX invests in front and second month futures contracts. For more on how this ETN operates, click here . If you wait until futures have re-entered backwardation to exit your short position in VXX then you lose some of the profit you could have locked in at a previous date. During the bull market, we have seen extremely long periods of contango which drags VXX down over time. If you are short these shares directly then you may be racking up holding costs by not exiting after a certain period of time. If you are short VXX using options, then you might not have the same concerns. See below for an updated table of the contango and backwardation strategy for VXX. Start dare (enters contango) End date (enters backwardation) Percent Change in VXX 5/21/2012 12/28/2012 -51.56% 12/31/2013 2/25/2013 -16.43% 2/26/2013 6/20/2013 -12.50% 6/21/2013 10/07/2013 -24.72% 10/10/2013 10/15/2013 2.9% 10/16/2013 12/16/2013 -12.02% 12/18/2013 1/30/2014 6.45% 2/7/2014 3/14/2014 5.52% 3/17/2014 4/11/2014 -0.44% 4/14/2014 10/9/2014 -27.37% 10/21/2014 10/22/2014 6.79% 10/23/2014 10/27/2014 2.15% 10/28/2014 12/12/2014 11.08% 12/17/2014 1/6/2014 10.1% 1/8/2015 1/12/2015 9.48% 1/21/2015 1/28/2015 7.6% 2/3/2015 7/8/2015 -35.58% 7/10/2015 8/20/2015 -8.7% 9/16/2015 09/17/2015 7.5% 10/08/2015 volatilityetfs.blogspot.com Table created by Nathan Buehler using historical data from the Intelligent Investor Blog . What you should notice from the above table is the very poor results from 10/21/2014 on. Overall the strategy is profitable but requires very long periods of contango to be highly successful. My exit timing After the VIX has reached a peak and volatility begins to wane, I will set a profit and time target once entering a short position. I prefer not to be in a trade longer than a month. The time frame is more of a risk management tool than about profitability. Generally I set a profit target of around 25%. Now my 25% profit target will not follow the above table because it is a mixture of options and inverse volatility products such as the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). To be clear on the time target, I am a worrier. You have to remember I am in a classroom all day and can’t really track what is happening in real time. The shorter I can make my profit target and get out, the happier I am. Waiting for backwardation to reappear can have two side effects. First, you are losing out on your full profit potential. Second, you are trading too often and instead of creating opportunities you are sometimes manufacturing loses. Current Advice Many investors initiated short volatility trades during the past few weeks. I encourage you to follow the above recommendations on exiting the position. Set a profit target and then close out the trade. A focus on U.S. economics should remain as any weakness will send the VIX surging again. So far, especially with jobs data, things continue to look positive. Seasonally volatility will wane after October and into the holiday season. All eyes are going to be on The Fed until liftoff. In case of a trend reversal be ready to lock in profits here. I have a small position in XIV and it has done better than I expected it to. Don’t force any trades here and never chase volatility on a fear of missing out. If you missed this one, wait it out for the next round. I highly appreciate you reading, as always!

Do Price Targets Matter In Volatile Markets? (And, Why Alpha Theory Should Be A Starting Point Even In Turbulent Times)

This blog was co-authored with Alpha Theory’s Customer Relations Manager, Dana Lambert. “Stock prices will continue to fluctuate – sometimes sharply – and the economy will have its ups and downs. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.” – Warren Buffett, famed investor “While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. “- Bill Ackman, Pershing Square 3Q08 Investor Letter The recent market environment has proven challenging for many funds, including Alpha Theory clients. The market has been volatile, but the real challenge is directionality. As of September 28, the S&P was down 11% over the prior 49 trading days, with 30 of the 49 days being down. Alpha Theory clients generally benefit from pure volatility (large ups and downs without a direction) because they are buying on dips and selling on rises (mean-reversion). The problem with a uniformly down directional market is that clients are continually getting indications to add to their longs and trim their shorts – the proverbial “catching the falling knife”. Although Alpha Theory cannot overcome persistent negative correlation between scenario estimates and outcomes – in other words inaccurate research – it does offer three options to help clients deal with these circumstances. OPTION #1 – RAISE PREFERRED RETURN. When the price of an asset falls, its probability-weighted return (PWR) rises. When the PWR rises, the normal action is to increase your position size. But when all asset prices fall, all PWRs rise and thus the longs become more attractive and the shorts less so. This suggested increase in long exposure may not be tenable and there may be a general skepticism regarding the price targets. In this situation, a manager can raise the preferred return for longs and thus raise the ‘hurdle rate’ required to be a full position in his or her fund (i.e., before you required only a 40% PWR to be a full position, but in this market environment you require 60%). This will immediately lower long exposure and only suggest adding to the best ideas. In the extreme example of February 2009, clients raised their hurdle rates to 70% or 80% and were able to see quickly numerous compelling ideas and how to shift capital appropriately. OPTION #2 – RELATIVE INDEX ADJUSTMENT. As the market falls, the “market multiple” decreases – which has ripple effects through the price targets in Alpha Theory. For those who cannot re-underwrite all of their targets for the new market paradigm, the application offers an easy-to-use feature called ‘Relative Index Adjustment’. This basically adds back the move of the market to an asset’s expected return, and the following would be an illustrative example. If the market is down 11%, then most assets’ prices will also be down and their suggested position sizes will increase. Now let’s turn on the Relative Index Adjustment. If every asset is down 11%, commensurate with the market move, then Alpha Theory will adjust the prices so that there is no change (-11% Stock Move minus -11% Market Move = 0% change) and thus no suggested change in position size. The beauty of this system is that you can turn it on and off and the Market Move is calculated since the last price target update. So if an analyst updates a price target, the Market Move gets set back to zero because the analyst would take into account the new “market multiple.” OPTION #3 – RE-UNDERWRITE CONSERVATIVE PRICE TARGETS. Fundamental investors recognize that there is no absolute intrinsic value for each asset because their assumptions are subjective. There is, however, a range of assumptions that span from aggressive to conservative. Down markets imply that pushing your assumptions to the conservative end of the spectrum may be appropriate. After doing this, you can see which assets are still suggested buys and which are not. The confidence imbued by using the most conservative assumptions allows you to be aggressive with add and trim decisions. A few views to help isolate where to start the re-underwriting process are: Performance view : shows those assets that have suffered the most on an absolute and relative basis Group by Risk/Reward within 10% : groups the assets that are within 10% of Reward and 10% of Risk targets (click to enlarge) While consideration of the aforementioned steps certainly is appropriate, as you develop conviction about downward directionality for the market, it is also worth noting that volatile markets can often be followed by periods of relative calm and distinct upwardly-biased directionality – and of course this has been the pattern for the past several years now. So where in one week an analyst or PM sees a 1-year target as likely to be unachievable, the next week suddenly the expected return gap narrows considerably. In short, just when you may be losing faith in your targets, they can quickly fall back into an attainable range. Directional markets that move quickly are challenging for many reasons. It is easy to throw up your hands and rationalize that “price targets don’t matter” or “our research is wrong”. It is hard to restrain those emotions and redouble your efforts to find the value that has been exposed in the quick, volatile relocation of asset prices. To do so requires a rigorous, disciplined process that begins with retesting assumptions (i.e., raising return hurdles, adjusting for the market move, and setting more conservative targets). If, after re-underwriting price targets and portfolio inputs, Alpha Theory is still recommending upsizings, then you can feel confident in your actions … even in a volatile, directional market.

Laclede Group: Aggressive New Management Is Performing

Summary Laclede doubled its enterprise value in two years via acquisitions. Debt and leverage has ballooned, but so has cash flow from operations. I’m not fully sold on recommending the shares for income investors until I see a solid bump in the dividend. The Laclede Group (NYSE: LG ) is a regulated natural gas utility that has begun making waves in the utility industry over the last several years. Through the acquisitions of Missouri Gas Energy from Southern Union in 2013 and Alagasco from Energen (NYSE: EGN ) in 2014, Laclede Group has shifted from a relatively small utility serving just a portion of the Missouri natural gas market to serving millions of customers, holding dominant market positions in both Missouri and Alabama. Shares in the company have rebounded nicely off early September lows and now trade at all-time highs. Are investors putting too much faith in the future of the company, especially given its less-than-stellar service area? Business Environment Utilities can add incremental revenue in two ways. They can either have customers consume more of the commodity, raise rates on current customers, or add new customers. The first method is unlikely, given that U.S. consumers are consuming less electricity per capita now than in prior years. The advent of energy conservation, more efficient appliances, and less household formation has ensured that the trend is going to remain in a slow slide downward outside of freak weather years increasing demand. With that off the table, utilities like Laclede Group could raise prices on consumers. Not going to fly, because as we know these are regulated operations and public utility commissions set the allowed returns. So the third option (influx of new customers) is really the only source and is something completely out of the utility’s control. This is why there is such a focus on market analytics when valuing utilities. Analysts look at all sorts of factors in the company’s service area: unemployment, average wages, past years’ population growth, etc. Sadly for Laclede, there won’t be much to like here. Missouri and Alabama rank average or below average on nearly every metric you could look at. Unemployment, salary averages, labor participation, poverty, etc. are all below average compared to other states. This scares away many investors, and rightly so. Until these states turn the corner and can draw in new inflows of people, Laclede should likely trade at a discount compared to better positioned peers. Operating Results There has been a lot of change for Laclede Group over the past three years. In fiscal 2011, the company switched CEOs to current leader Suzanne Sitherwood, who made quick work of making changes within the company. Within a few short years under her leadership, the company had sold off its propane assets, made $2.2B worth of acquisitions, and driven up profit/operating margins. Acquisition and expansion don’t come for free, however. Long term debt has spiked from $340M in 2011 to over $1.7B today. Net debt/EBITDA has expanded from a low of 2.1x in fiscal 2011 to what should be around 4x in fiscal 2015. While this is a manageable level of debt for a utility, long-time holders of Laclede should be aware that the risk profile has changed dramatically under the new management style. Excluding the impact of the acquisitions on the cash flow statement ($2.2B paid for with approximately two thirds long-term debt, one third stock offering) things actually look pretty good. Cash from operations is set to fly high in 2015, with the business generating more cash in 2015 than in the prior three years combined. Capital expenditures, like is the case for most natural gas utilities, are comparatively low and under control compared to other utilities that operate in power generation. Results here are ideal and indicative of how I want to see a utility being managed in respect to cash in/cash out. Conclusion Ballsy moves aren’t something the utility industry is known for. Laclede has bucked this trend by engaging in acquisitions that doubled its size in just a few short years. There will be growing pains associated with the acquisitions that may impact short-term results, but I think thus far it looks like company management has made the right play and acquired some solid assets that will easily be folded under the Laclede umbrella. I think investors see the potential here, which is why shares have performed so strongly. For income investors considering entering a position, however, I think this is a “show me” story. Historical dividend growth has been lackluster and I think investors considering going long should wait to see what the next dividend increase pans out to be in fiscal 2016, which should be announced over the next few months. A bump in the 5%+ range would show that management is hitting their targets while also being shareholder friendly.