UVXY ETF: A Second Quarter Play On A Market Shift

Following a bullish six months, Q2 has got off to a less impressive start and change is in the air as “higher for longer” expectations for rates are finally having an effect. The S&P 500 (SPY) has broken the trend support in place for over two months and has already made its largest (-2.39%), and longest (14 sessions) decline since October last year. Meanwhile, the 10-year yield has broken above 4.335% resistance from the 2022 peak and is making new 2024 highs. Even the S&P VIX Index (VIX) is climbing higher.

It could be a good time to hedge and even profit from a stock market downturn. This article looks at the ProShares Ultra VIX Short-Term Futures ETF (BATS:UVXY) as a potential short-term trade in Q2.

The VIX Could Pop Higher

Volatility is creeping slowly higher after making a low of 11.81 in December when dovish expectations reached their peak. At that time, markets expected six cuts in 2024, starting in March. Fast forward to today, and those dovish expectations have eroded, and a first cut is now only expected in September. That would limit the Fed to only three cuts even if they cut at every meeting from September onwards.

So far this year, the S&P 500 has shrugged off the delay to rate cuts, mostly as the economy has been so strong and earnings estimates are optimistic. This has limited the gains in the VIX, although it has been making higher lows. However, this week’s headline CPI came in at 0.4% for the third time in a row, and it looks like stocks may finally take notice of the “higher for longer” path for rates. After an initially slow advance, the VIX could make one of its classic ‘pops’ higher if it breaks above 17.

Goldman Sachs’ model of the VIX uses five economic variables to predict the VIX level and points out volatility typically rises in the spring. It estimates the VIX should be at 21 in April and could rise to 28 during a macro shock.

According to the VIX rule of 16, if the VIX is trading at 21, the SPX is estimated to have average daily moves of 1.31% (21/16=1.31). Four out of the last five sessions have had daily ranges over 1.3% so a VIX reading of 21 looks quite achievable in the coming weeks.

Trading the VIX Pop

An easy way to position for a gain in the VIX is through UVXY. UVXY, according to the Fund Page, “seeks daily investment results, before fees and expenses, that correspond to one and one-half times (1.5x) the daily performance of the S&P 500 VIX Short-Term Futures Index.”

This is a leveraged product and is balanced daily, so the usual effects of negative compounding are a risk. Moreover, the way the fund is structured means it periodically needs to roll into new monthly VIX futures contracts, often at a loss when the VIX contracts are in Contango. As the Fund page warns,

The Funds are benchmarked to an Index of VIX futures contracts. The Funds are not benchmarked to the widely referenced Cboe Volatility Index, commonly known as the “VIX.” The Funds should be expected to perform very differently from the VIX or one and one-half times (1.5x) or one-half the inverse (-0.5x) of the performance of the VIX, as applicable.

Needless to say, this is not a product to hold long-term. Even as the VIX has made higher lows all year, UVXY has been working lower and has only recovered slightly in recent weeks.

That said, it could have more upside. As already mentioned, the S&P 500 has made its largest drop since the rally started in October ’23 and volatility is clearly increasing. However, UVXY has not made a noteworthy gain, yet, and I would expect it to at least reach the $9-10 area should the VIX reach 21.

Other Considerations

The expense ratio of UVXY is 0.95% which is on the high side, but not really an issue given the size of the swings. UVXY has already made a 10% gain in April and could rally a further 45% if the VIX hits the 21 target.

UVXY is a small fund with only $260M AUM. However, liquidity is excellent due to the liquidity in VIX future contracts. The average Daily Dollar Volume in UVXY is $187.20M.

Trading UVXY carries major risks due to volatility in the VIX. I would say, however, that the VIX tends to spike higher before reverting to the mean and spiking lower again. i.e. the sharp moves lower tend to come from an elevated position rather than a depressed position like the VIX is in now.

As we cannot expect a sustained uptrend, any large move higher in the VIX should be seen as an opportunity to take profits.

The major risk is that the S&P 500 corrects sideways in a low volatility range and VIX fails to pop higher. In this scenario, the negative roll in UVXY will lead to losses which could be substantial. Over the long term, I fully expect UVXY prices will break below $1 and never fully recover. I therefore recommend to cap losses at a specific price (stop loss), or treat a UVXY like an option which can go to zero. Personally, I will not hold UVXY below $6.

Conclusion

Q2 has brought a shift in markets, and the S&P 500 has made its largest correction since the rally began in October ’23. Volatility is increasing and the VIX could pop higher to around 21. This makes UVXY an attractive short-term trade, with the usual caveats that it is an extremely high risk ETF.