2017: Trading for Dummies

2017 was the year that volatility died. No other year even comes close to the number of low VIX readings in the 8's and 9's. Records continued to be set in 2017 and each time VIX spiked just a little bit, baseline volatility settled to an even lower level afterward. Even the VIX high for the year was minor by historical standards. During a brief August pullback, VIX hit a high of 17.28. For perspective, there have been some years where the VIX would never have dropped below that level. The index has not been above 20 since the 2016 election. 

2017 Weekly VIX Chart. Nothing to see here.

Looking at the SPX, the low for the year happened on January 3, the first day of trading. The high happened less than 2 weeks ago on December 18. There's been a very steady march upward all year, broken only briefly by minor pullbacks. Those waiting for lower prices to get in were repeatedly left behind and bears were nowhere to be found. Even the brief August spike in volatility barely shows up on the 2017 SPX chart. Every month was positive in 2017.

2017 Weekly chart SPX chart

 

The slow, steady, and persistent nature of the market's climb was reflected in the low VIX readings all year, making it incredibly easy to trade volatility on the short side. Even though volatility was low, the structure of VIX futures remained in contango, so all of the short volatility funds had terrific performance selling more expensive VIX futures and buying them back at lower prices. A simple buy-and-hold of the short volatility funds would have had the following returns in 2017:

2017 Returns:

SVXY: +170.7%

XIV: +175.5%

VMIN: +109.6%

Shorting the long volatility funds without rebalancing would have yielded the following returns (before any borrowing fees):

2017 Returns (inverse/short):

UVXY: +93.6%

TVIX: +93.6%

VXX: +71.4%

VMAX: +81.5%

It's clear to see that one didn't even really need to trade these funds in 2017. If one had the stomach to handle a few 15-20% drawdowns along the way, a simple entry on the first trading day of the year would have yielded impressive results with no skill or effort required. 2017 was volatility trading for dummies.

It's not surprising that “expert” volatility traders seem to be showing up in every corner of the internet now. With such extreme complacency, it's common to see the promotion some very aggressive, and unwise trading methods. Overexposure, excessive leverage, and poor entry selection all could come back to bite short volatility traders. In 2017, it was fine for a trader to short UVXY and have it move against them 20% because it dropped back to new lows fairly quickly, leading many to believe that profits are a sure thing and these funds always go down. “Never cover” became a mantra among many because why not? It's worked for the last two years.

But even as recently as 2015 that same strategy would have wiped out many positions. Here are some of the recent massive spikes in volatility and how the associated funds performed:

2017 didn't have any such volatility spikes so it's easy to develop bad habits – not setting stops, using excessively large position sizes, not being patient, or ignoring trade rules for fear of missing out. While I'm not sure when or how much volatility will rise next, the only certainty is that it will. Traders that allowed themselves to develop these bad habits out of complacency will get hit the hardest.

You've undoubtedly heard the term “disaster preparedness.” Now would be an excellent time to develop your disaster plan for the next volatility event. How do you plan to manage positions when facing the possibility of serious losses? How would your current volatility position change if VIX were to double in a couple days? How about if UVXY tripled again like it did in 2015? What would happen if VIX goes to 50? What if volatility continues to rise even after a new short entry – how long do you stay in? Or what if you are short UVXY and your shares are taken away at the worst time possible and you have to book a loss? Where is your exit? Do you have an exit? How will you invest if we enter another prolonged period of volatility? These are questions every trader should be asking themselves when developing a trading system. It may not be “good enough” to have a large cash cushion. It may not be possible to ride out the next spike. “Buy the dip” or “short the spike” will not work again at some point.

I don't claim to have a perfect system, and despite countless weeks and months of research, I have yet to find a good signal that tells me when to exit before it hits the fan. But at least my 2018 resolution will be to know what I don't know and continue to improve my trading habits. I'll manage my positions wisely and take on less risk where possible. I'll also have an exit and entry plan and stick to it so I don't let fear or greed paralyze me or cause panic. At least I'll know that by doing so I'll live to trade another day. And there will be some terrific days ahead.

Have a great and prosperous 2018, and happy VIX trading!