How to Safely Play the Short Side of This Market

You’d be hard pressed to find an investor in this market who doesn’t have some concern over the valuations we’re seeing in domestic equities. We’ve been in and out of short positions for the past four months, continually forced to cover on the next low-volume, yet explosive leg up. A frustrating experience to be sure, but we’ve been on the look out for easier ways to play the short side without being exposed to all the upside risk.

We believe that the VIX may be a space we can achieve a good risk-reward set-up while staying short the broader market. Looking at returns on the S&P 500 and the VIX over the past 6 and 3 months, it’s clear that the VIX has actually been worse to hold than an S&P short, nevertheless we don’t believe this tells the whole story of the current set up. First, to give you an idea of the technical levels in the VIX, here’s a 5-year chart:

ts fairly obvious that the VIX has a major technical level of support around 20. Prior to the onset of the credit crisis, volatility remained subdued beneath this level for the 2004-2006 period. In fact, if we look back at the maximum range of the VIX, calculated by the new methodology, its clear that the 20 level has been the focal point for the life of the index.

Throughout the 1998-2003 period, volatility plagued the market, with the LTCM crisis and the collapse of the tech bubble, and the VIX hovered above 20. Despite almost three years of 20+ levels, it’s clear that this heightened volatility isn’t necessarily abnormal, but perhaps even healthy. That being said, 20 represents support from a technical standpoint and we’d suggest there is low probability that penetration of this level to the downside will occur on the first, or even second try. If we look at the ‘98-’03 period, the VIX dipped below 20 only to pop back at least 3 times. Additionally, it’s also becoming clear that the VIX has broken out of its sustained downtrend of the past 11 months and is establishing a range of stability between 20 and 30.

What does this mean to those interested in going short the S&P 500? The VIX provides a far better risk-reward scenario for shorts than a short of the broad equity index does. If you need further proof of the significance of that 20 level, observe the spikes of the VIX during relatively mild S&P pullbacks over the previous 3 months, validating the support here:

Though the VIX has performed worse than an S&P 500 short in aggregate over the prior 3 months, we believe that the VIX’s new range of technical import has shifted the setup. A buy between 20 and 22 can serve as a highly effective short play with little risk of a breakdown below 20.

Scenario 1: Equities rally sharply upward, sending the VIX below 20 and into something like its 2004-2006 range (Probability: Very Low). In this case, we advise selling the VIX if it sustains a break below 20. This scenario has the advantage of having a well-defined exit point.

Scenario 2: Equities continue a tired rally. The VIX remains above 20 and gives powerful upside when equities pull back. (Probability: ~50%) This scenario is optimal because it allows us to stay short while maintaining capital because we bought the VIX close to 20. Additionally, if equities see a more sustained pullback (perhaps leading to a double-dip), we stand to book some solid gains.

Scenario 3: Equities pull back, VIX breaks out above 30. (Probability: ~40%). This is our best-case scenario. If we buy VIX at 22 and sell it around 40 we’ve achieved a very good 81% return, considering the levels we’d need to get this same return on the S&P are far beyond Armaggeddon.

Source: Seeking Alpha