Utilities as an alternative to volatility products

Key Points

• Optix among volatility traders just reversed from an extreme reading
• A reversion to the mean for volatility products (such as VXX) typically follows
• Volatility ETFs and ETNs and options on those vehicles can be tricky to trade
• A more straightforward approach might be to buy a utility ETF

VXX Optix reverses from an extreme

Ticker VXX (iPath S&P 500 VIX Short-Term Futures ETN ) is an exchange-traded note designed to track the performance of short-term VIX futures). Because of its construction, its price ultimately trends towards zero (which makes it an odd trading vehicle), except during those brief periods when the VIX Index "spikes" to sharply higher levels. Of course, human nature being what it is, when volatility does spike, higher investor sentiment regarding the expectation of even higher volatility also tends to spike. And then, just as inevitably, it tends to reverse quickly.

The chart below displays ticker VXX and those days when the 5-day average for VXX Optix dropped back below 80.

NOTE: The latest signal occurred after the close on 1/28/2022.

The table below displays a summary of the performance of VXX following the signals in the chart above.

Note the universally negative results. There is the potential for gain for traders who are willing to short shares of VXX (or to sell call options on VXX). However, these approaches - while perfectly viable - are fraught with peril for the simple reason that if the "spike" in volatility continues or resumes, significantly large losses can accumulate quickly. So let's consider an alternate approach.

XLU as in inverse proxy

The chart below displays ticker XLU and those days when the 5-day average for VXX Optix dropped back below 80.

The table below displays a summary of the performance of XLU following the signals in the chart above. Of particular interest is the 81% Win Rate 1-month later.

In a nutshell, the idea is that instead of shorting highly volatile shares of VXX - or selling options - a trader might consider buying shares of XLU instead.

The chart below displays the hypothetical growth of $1 invested in XLU for one month after each time VXX 5-day average Optix drops below 80% (NOTE: The holding period is extended for another month if a new signal occurs within one month of a previous signal).

What the research tells us...

The stock market typically experiences a "reversion to the mean" following a spike in the VIX Index (i.e., the market typically falls as VIX spikes and then rallies as VIX cools off). The utility sector appears to offer one possible avenue for traders who wish to take advantage of this trend without trading volatility products.