Why do we follow trends? The answer is that for decades, trends have been the only way to capture the market’s most significant price moves.
Many market participants make a mistake by attempting to identify market tops or bottoms in the leading indices, individual stocks, or the many other investments and trading assets. During bull and bear markets, asset prices tend to move far higher or lower than reasonable, rational, and logical analysis dictates, making picking a top or a bottom more about ego gratification than making profits.
Some market participants open or close risk positions based on the latest news. Trading or investing on the ever-changing news cycle causes choppy results at best or consistent losses at worse. Many news stories have the opposite impact on prices that logic dictates.
Markets do not always trend; they sometimes chop around equilibrium levels. In those market conditions, we experience small losses. However, when significant trends emerge, we are always on board as our highly liquid portfolio is always long or short every asset. We wind up long at tops and short at bottoms, but we consistently take the lion’s share from trends when they occur.
No one calls markets correctly all of the time, and the path to success is one where profits outnumber losses. We have been trading and investing since 1980 and have found that an algorithmic approach provides optimal results over time. The iPath Series B S&P 500 VIX Short-Term Futures ETN product (VXX) is a highly liquid product that tracks the VIX volatility product on the S&P 500 index. VXX is a component of our APS portfolio.
VXX moves with the VIX Volatility Index
The iPath Series B S&P 500 VIX Short-Term Futures ETN is a leveraged product derivative of the VIX volatility index. The description outlines the product’s construction and goals:
The iPath SP 500 VIX Short-Term Futures ETNs (the ETNs) are designed to provide exposure to the SP 500 VIX Short-Term Futures Index Total Return (the Index). The Index is designed to provide access to equity market volatility through CBOE Volatility Index (the VIX Index) futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects market participants views of the future direction of the VIX index at the time of expiration of the VIX futures contracts comprising the Index. [Source: Barchart]
VXX moves higher and lower with the first and second month VIX futures index. VXX is a liquid product with over $630 million in assets under management and over 84 million shares changing hands on average each day. VXX charges an 0.89% management fee.
Implied volatility determines the direction
According to the CBOE website, the VIX index is a compilation of the implied volatility of put and call options in the SPX or S&P 500 Index. The VIX is “weighted to yield a constant maturity 30-day measure of the expected volatility of the S&P 500 Index.”
Historical volatility is the price variance measure of an asset in the past. The 30-day historical volatility measure is an objective metric calculated on price movement.
Implied volatility is the price variance the market projects will occur in the future. Implied volatility is the primary determinant of put and call option premiums. The compilation of put and call premiums of stocks in the S&P 500 establishes the VIX level. VXX is a derivative of the VIX Index as it moves higher and lower with the implied volatility of the S&P 500 put and call options. As a daily ETN product that is periodically rolling with futures contracts based on options premiums, theta or time decay impacts the VXX product. Time decay in options occurs as they move closure to expiration and the extrinsic or out-of-the-money portion of the put or call option erodes.
The VXX tends to rally during corrections – rising or stable markets are bearish
VXX is a product that moves higher or lower with implied not historical volatility on the S&P 500 stocks. Implied volatility tends to increase during market corrections and decrease when the S&P 500 moves higher or remains stable.
Options are price insurance, and the demand for insurance rises when risks increase. In the stock market, the demand for insurance increases when investors and market participants get nervous and scramble to insurance equity portfolios. Since the S&P 500 is the most broad-based measure of the stock market, the VIX is a leading indicator of market participants’ demand for price insurance.
The odds favor the downside, but the trend is currently bullish
The VIX index and VXX product suffer from time decay, but that does not mean it does not periodically spike higher.
The chart shows the dramatic spike that took VXX to a reverse split-adjusted high of $315.36 in March 2020, when the global pandemic caused substantial selling in S&P 500 stocks.
Meanwhile, stocks can move higher, lower, or remain the same. Up, down, or sideways are the three potentials for price action. Since the VXX only appreciates during S&P 500 declines, the odds favor the downside in the product that follows the VIX as the three choices offer an only 33.33% chance of a decline in stocks and rise in the VIX.
When the VXX product reaches a low level, a reverse split adjusts the product to a higher level.
The VXX product is for trading, not investing. The last reverse split occurred on April 23, 2021, when it underwent a one-for-four reverse split. The product tends to experience a reverse split when it reaches the $10 per share level.
APS is long VXX because it follows trends
VXX is a trading tool. The APS is always long or short VXX but tends to be short because of the product’s time decay. However, as we witnessed in early 2020, the VXX can deliver substantial profits on the long side when the trend turns higher.
As of February 18, 2022, the APS was long the VXX ETN, the product that follows the VIX Index. When the trend bends and our algorithm turns negative, we will close our long and go short the VXX.
Following trends via an algorithmic system requires strict adherence to rules. We do not attempt to pick bottoms or tops in any markets and are typically short at bottoms and long at tops. However, taking the most significant percentage out of trends requires removing emotional impulses from trading and investing. We ignore fundamentals, news, and all of the daily noise. Our signals are never intraday; they can only change at the end of a session. Our system does not get caught up in the daily frenetic trading activity.
The price of any asset is always the correct price because it is the level where buyers and sellers meet in a transparent environment, the marketplace. Crowd behavior that determines trends can be the optimal approach to markets across all asset classes. As of February 18, the crowd’s wisdom points to a bullish trend in the VXX ETN product.