The Best Trump Trade No One Expected

The best-performing trade since the election is not what you think.

What's the best-performing trade since Donald Trump was elected president? Even today, with the benefit of hindsight, a lot of people might not know. Go back a few months to November, or even earlier, and no one in their right mind would have predicted it.

As surprising as it sounds, a bet on declining volatility is the top trade since the elections and of 2017 so far.

That's astonishing, because, if anything, most analysts were calling for just the opposite―a rise in volatility from the uncertainty that a Trump administration brings. His unpredictable policies, especially when it comes to trade, would inevitably lead to large fluctuations in the stock market, they argued.

Perhaps those prognostications will eventually come true. But as a recent Bloomberg article points out, volatility has been below average for the past five years; it will take a much more significant spike in stock market fluctuations before those calling for higher volatility are proven correct.

Lowest VIX In A Decade

In the meantime, the CBOE Volatility Index―a measure of implied volatility based on S&P 500 options―continues to fall. The VIX, as it's commonly known, briefly dropped below 10 for the first time in a decade earlier this month.

Of course, that won't last. A market sell-off and at least a temporary increase in volatility are inevitable. The VIX is mean-reverting, something that's clearly reflected in the futures curve for the index. For example, VIX futures for the month of October were last trading at 18.5, much higher than "spot" VIX or the front-month February contract (a situation known as contango).

As spot VIX and front-month VIX contracts dropped by 42% and 27%, respectively, since the elections, longer-dated contracts fell by much less. This has resulted in a steepening of the VIX futures curve.

Source: Bloomberg

That's been money in the bank for anyone betting on falling volatility, including holders of inverse VIX exchange-traded products. A strategy of shorting near-month VIX futures contracts has benefited both from the decline in the prices of those contracts and "roll yields" from the steep, upward-sloping futures curve.

Strategy Working Brilliantly

Here's how it works. An exchange-traded product that shorts front-month VIX futures contracts must roll that position forward as the contracts' expiration date approaches. It does this by closing out its front-month short position and re-establishing it on the higher-priced second-month contract.

Currently, the second-month contract is about 14% higher than the front-month contract―13.38 compared with 11.73. If volatility stays low or continues to decline, inverse VIX products gain as the new contract drops to where the old one was, or even lower.

This strategy has been working brilliantly since the elections and even over longer time periods.

The VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY) returned more than 70% each since Nov. 8. Both products provide inverse exposure to first- and second-month futures contracts with a weighted-average maturity of one month.

The REX VolMAXX Short VIX Weekly Futures Strategy ETF (VMIN) launched less than a year ago and has done even better, rocketing up nearly 97% in the three months since the election. VMIN shorts VIX futures with less than one month to expiration.

Returns For XIV, SVXY, VMIN Since Nov. 8

After such large gains, it's natural to question whether the easy money has already been made in these products. Certainly, when the next stock market correction hits, inverse VIX ETFs will get clobbered.

Last year, when the U.S. stock market had its worst start to the year in history, XIV and SVXY dropped nearly 40% in January and February. But since that point, they've almost tripled. Go back five years and they're up more than 600%. That's quite a track record for a trade that was supposed to stop working after the election of Trump.

At the time of writing, the author did not own any of the securities mentioned. Contact Sumit Roy at [email protected].