Why a crowded VIX short isn't equity bearish

Mid-week market update: Two weeks ago, I had forecast a minor stock market pullback as the SPX neared 2200 (see The market catches round number-itis). The corrective move hasn't happened and remain in a tight trading range. The one bright spot for the bull case is stock prices haven't fallen in response to bad news, such as the surprising shortfalls in both manufacturing and services ISM in the past week. On the other hand, the tight trading range appears to be encouraging traders to short volatility, which is worrisome.

I've become increasingly concerned about a prolonged crowded short reading by large speculators on VIX futures. Here is the chart from Hedgopia.

The crowded short position by large speculators is worrisome because it invites a disorderly unwind of the shorts, which would lead to a spike in volatility. As the VIX Index tends to be inversely correlated with equity prices, VIX strength would therefore translate into equity weakness. At the same time, the SKEW Index indicated a heightened appetite for tail-risk protection.

As both my inner investor and inner trader have adopted bullish views, the prolonged period of an extreme net short VIX position was a nagging concern - until I realized the explanation for traders to be short VIX. Using the new analytical framework, these readings did not appear to be equity bearish at all.

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