When an esoteric financial product becomes the topic of dinner parties, savvy traders know to take notice. Every financial boom goes through several stages: professionals ride the first wave of price increases; increasingly they sell out to parties who do not normally trade the object of speculation but are attracted by price increases and the prospect of easy money. The public buys into the final stages of the boom and ultimately is left holding the proverbial bag. An adage to sell when your “shoeshine boy” is talking stocks has morphed into the Starbucks Barrista. I know to sell when my financially illiterate acquaintances are lecturing me about the merits of Volatility ETFs. Given the myriad of myths I had to dispell at a recent get-together, I think a blog post is more than overdue.
As you can see from the chart above, search volume for two of these ETF’s is nearing its highest on record. In general, there are 5 misconceptions that most traders have regarding Volatility ETFs such as UVXY, VXX, or SVXY:
- Why do Volatility ETF’s not track the VIX directly?
- ETF’s such UVXY do not trade the VIX: the VIX is a mathematical formula that cannot be traded directly
- Instead, they trade the VIX Futures Curve
- For example, SVXY and XIV short the first two VIX Futures contracts
- What is a VIX Future?
- Traders can speculate what the future value of the VIX will be using a VIX Future
- For example, suppose the spot VIX (the current VIX as calculated by CBOE) is 15.0 and the March 2015 VIX Future is trading at 18.0. If I think that by March 2015 the spot VIX will still be 15.0, I can short the VIX Futures contract at 18.0, and make 3.0 * $1000 = $3000 a contract if I am correct. Likewise, if the VIX is in fact 30, I will lose $12,000 per contract.
- What is a Futures Curve?
- Like options themselves, VIX Futures have many expiries. This chain of contracts forms a curve in the same way futures contracts for Corn, Wheat, Oil, and Eurodollars do.
- VIX Futures have contracts for each month going forward about 9 months.
- The shape of the VIX curve is especially important to Volatility ETF’s, as they are constantly “rolling” contracts from the front of the curve to the back as the front month contract approaches expiration.
- Is the VIX Futures Curve Always Increasing?
- For most of the time since 2009, the VIX Futures Curve has been increasing, but there is nothing that guarantees this to be the case.
- During the current bull market in equities, traders have remained fearful of another collapse like we experienced in 2008, and have sought protection in longer term options and products like long dated VIX Futures.
- While the spot VIX has remained low (averaging just 14 in all of 2014), further dated VIX Futures prices have remained high reflecting a high price for tail risk protection
- During times of crisis, however, the curve can enter backwardization: where the spot VIX is higher than the front end of the curve and the back end is the lowest price.
- The front end of the curve follows the spot VIX much more closely than the back, which reflects more the longer term mean that traders think the spot VIX will adhere to.
- Why do Leveraged Volatility ETF’s perform so badly, even when there are big moves in the spot VIX?
- All leveraged ETF’s experience a decay due to their daily rebalancing and leverage.
- For example, suppose an index moves down by 10% then up by 11.11%, i.e. it stays at the same price (0.9 * 1.1111 =~ 1.0)
- Suppose there is a triple levered ETF for the index which moves down by 30% then up by 33.33%. The levered ETF will actually be down by 6.67% even though the index is unchanged (0.7 * 1.3333 = ~ 0.93333)
- Over time this decay brings down the value of the ETF vs the index it is designed to track
Categories: Quantitative Trading