They say there are only two certainties in life: Death and Taxes.  Of course, as a colloquialism, it is a truism, but you could add to that list a great many other certainties. “I’m certain to not get any younger”, sadly speaking of course! One additional such certainty would be VIX-leveraged ETP decay.  And what better way to address participating with VIX-leveraged ETPs like ProShares Ultra VIX Short-Term Futures ETF (UVXY ), VelocityShares Daily 2x VIX Short-Term ETN (TVIX) and iPath S&P 500 VIX Short-Term Futures ETN (VXX) than with a correlated subject matter like death and taxes.  The death characteristic is aligned for the decay characteristic as a happenstance. I didn’t plan it that way, but what a coincidence!  So in this article/discussion regarding VIX-leveraged instruments and their intrinsic decay let’s discuss our obligated tax burden from capital gains. Short-term capital gains refer to the profits made on investments held for one year or less. They are taxed at the same rates as ordinary income. Below is the current tax rate/bracket for short-term capital gain and assuming single filer status.

Obviously, from the table above, short-term capital gains are taxed more heavily the higher one scales their income/capital gains. Additionally, they carry a higher tax rate than long-term capital gains, much higher actually.  In short, no pun intended since we are discussing short instruments within when closing out short positions keep in mind your tax rate potential and trade or invest accordingly.  Unfortunately, depending on how one looks at it, I fall into the highest income tax bracket.  Moreover, I do a good deal of short-term trading with UVXY and TVIX.  As a portfolio manager, it is up to me to keep track of these daily, weekly or monthly trades and assign the appropriate capital gains to these trades based on my “ins and outs”.  I always assume the highest tax rate so as to introduce a margin of error that won’t exhibit a negative surprise come tax season.  Having said that about short-term trading, I maintain a long-term core position in shares of UVXY and have done so since 2012.  It’s only on day 366 of holding core positions/shares that I will consider covering these positions and where to do so. 

This year already I have executed two large block buy-to-cover orders on my 20% weighted position of UVXY shares within the Golden Capital Portfolio.  The most recent buy-to-cover order was executed at the UVXY trading price of $19.10 as indicated in my tweet below.  

(Click on image to enlarge)

From a weighted 20% position entering 2017, my two large block buy-to-cover orders have reduced my total holdings as a percentage of allocated capital in the Golden Capital Portfolio to 15.8 percent. 

While I have mentioned in previous articles that one of the reasons I maintain a long-term position is to ensure shares are made available for me to short, another reason is to limit my tax liability.  Many times individual investors have expressed the baffling reason as to why I maintain a core short position in UVXY long-term. The argument against doing so is, more often than not, the maximum potential of the short being 99.999 percent.  I fully recognize and agree with that potential profit scale, but I’m ok accepting that fantastic potential and aligning my tax liability to express the least amount of liability possible.  While limiting my tax liability and capturing the inevitable 99.999% profit potential, I’ve actually accomplished two major objectives.  Don’t get me wrong, these are two outstanding accomplishments, but another one is the limiting of backwardation on my capital investment, as I will explain.

By holding a core short position in UVXY long-term I’m able to benefit even further when the ETF expresses a reverse split.  Nearly every year the instrument expresses a reverse split, lowering my total number of shares, but not necessarily my total capital exposure.  Let’s take a look at the following example of a long-term investment in UVXY starting from $30 a share.

• 1000sh X $30 per/sh = $30,000 invested capital.  From here the stock goes all the way down to $6 per/sh.  Total profit thus far is 1000sh X $24 move = $24,000.  Not a bad investment right! Rhetorical obviously, and for as quickly as it comes, a market leading return on capital invested, usually. 

• And now here comes the reverse split from $6 a share back up to $30 a share, to use round numbers for the sake of simplicity.  Your 1,000 shares just got reduced to 200 shares in a 1:5 reverse split.  The number of shares is much less even as the capital invested doesn’t change nor does the profit in hand. 

• What if shares didn’t split though and UVXY went backward, back up to say $12 a share?  Well on the 1,000 shares you would have given back $6,000 of that paper profit right? Again, with the rhetorical!  But UVXY did split and now you only have 200 shares. So what if UVXY climbs the equivalent $6 from the reverse split price of $30 to $36 a share as volatility spikes and VIX Futures spike as well.  200sh X $6 per share = $1,200.  See how that works! Follow me…

So do you see how many benefits, assuming an account can maintain liquidity through backwardation, holding a long-term short core position in UVXY and like VIX-leveraged ETPs can be for your portfolio?  Let’s list them for fear of ambiguity below:

• Short share availability
• Limit tax liability
• Limit paper/or real losses from backwardation
• Restful nights ;-)

VIX-leveraged ETF traders/investors have been experiencing restful nights since 2011 by and large. So where do these VIX-leveraged instruments go from here?  Regarding backwardation…please can we get some!!  Most long-term oriented participating investors desire some level of backwardation as the complacency in the markets has actually limited the potential profits in these instruments, relatively speaking of course. The more spikes in volatility, the greater opportunity to profit from the eventual decay/death spiral of these instruments.  There has not been a significant backwardation in UVXY since the Brexit event in June of 2016.  For those that had cash on hand and layered short positions into the event, they were greatly rewarded thereafter and as VIX-leveraged ETF decay set in. 

Volatility has been a bit of a conundrum over the last few years.  That level of confusion has exacerbated in the last several months with the VIX itself below 14 for an extended period of time.  What I believe many analysts and/or investors fail to appreciate about the nature of volatility is its ability to adapt as investors become desensitized to fear.  Is such desensitization healthy; I would offer it is not healthy. More importantly I would offer the recognition of such an occurrence could offset this variable of consideration. Investors have arguably experienced the worst of times, as we know them to be or can imagine them to be.  From the savings & loan crises, 9-11 and the most recent Financial Crisis, investors have experienced great hardships only to find resilient equity markets. And these markets have experienced these events to exhibit all-time trading level highs.  Along those lines, investors express the ability to perceive fearful situations in economies and markets with less fear than in previous decades, as proven by the VIX.  This desensitization of fear can be directly correlated to prolonged, low levels of volatility/VIX, even on the average. 

Moreover, correlations regarding volatility have seemingly become disconnected.  One such correlation is high-yield bond spreads and the VIX.  Over many years, this correlation has been quite strong, but more recently the correlation has become distanced to a degree not witnessed in almost 15 years.

Could this disconnect be the precursor to realignment of junk bond spreads and the VIX or the realization of how desensitized to fear investors have become? It remains to be seen.  But also keep in mind as it pertains to instruments like UVXY and should realignment occur with the VIX spiking, the standing position and contango during alignment will determine how much backwardation occurs for UVXY and like instruments.  Additionally, based on the trending disconnect in high-yield bond spreads from the VIX, we don’t know if the VIX would spike to connect with the spread or those bond yield spreads would come down to align with the VIX. Furthermore, we’ve not experienced as a financial institution the unintended consequences of “manipulated bond yields” through the process and completion of quantitative easing measures that included bond purchases by central banks. What was may not be, for better or for worse.  Nonetheless, it’s something to consider when participating with VIX-leveraged instruments. 

Death, Taxes and UVXY/TVIX/VXX intrinsic decay: Just three of the many certainties in life over the span of a lifetime.  If I were to take on the personality of the Dos Equis character from the well-received commercials, I would offer the following to VIX-leveraged ETF investors/traders:

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“Maintain liquidity my friends”! I’m not the most interesting man on Earth, not by a long shot.  Good luck traders and kindly review my detailed articles concerning VIX-leveraged instruments at Talkmarkets.com! Participate and plan accordingly with a healthy appreciation for all instrument variables.