Misconceptions About Volatility ETF’s

Google Search Volume for SVXY and UVXY, two popular VIX Futures ETF's

Google Search Volume for SVXY and UVXY, two popular VIX Futures ETF’s

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:

  1. 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
  2. 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.
  3. 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.
  4. 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.
  5. 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

7 replies »

  1. I have traded both UVXY and SVXY since mid 2012. I have been watching the VIX contract prices like a hawk over the past six months and something is not right. Currently the SVXY is at $68 and from watching contango and option prices this etf should be well over a $100 right now, closer to $115. Back in July it was at $93 and there has been about a week and a half where it has been in backwardation of about 7% and the other 4 1/2 months it has been anywhere between 5-15% contango. The SVXY and the UVXY are inverse of each other and since July the SVXY has dropped by 26% and the UVXY has dropped by almost 20%. Any thoughts on this?

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  2. The apparent paradox occurs due to structural issues in these ETFs. Think of UVXY and SVXY as pools of capital. They use this capital to go long (UVXY) or short (SVXY) VIX futures contracts. That is, like anyone else they attempt to buy or sell futures contracts on the open market. Like the rest of us, the funds experience transaction costs in the form of commissions and slippage. Unlike the rest of us, these funds are “hard-coded” to perform a rebalancing of its porfolio at the end of each day (around 4-4:15pm), shifting a percentage of its position from the front contract to the next.

    This time of reblancing coincides with the time of day that VIX futures are most volatile. Traders play games with rebalancing algorithms which amounts to a tax on the holders of UVXY and SVXY. The more volatile the VIX futures the greater the cost of this tax. Since the VIX itself has been so volatile, the futures curve has been crazy as well, creating a negative drag on each volatility ETF just from slippage and transaction costs.

    Moreover, the very nature of ETF creation and redemption creates a momentum to these ETFs. For example, during normal markets when spot VIX is low and curve is increasing, traders will pay a premium for SVXY which causes more shares to be created and thus more VIX futures contracts get shorted by the fund. If traders are right and spot VIX stays low then the fund makes more money, attracting more buyers, increasing the short futures position and so on. As long as markets remain normal then this imparts a positive momentum to SVXY and the funds assets continue to increase in response.

    When equities markets get volatile and the VIX spikes it can invert the VIX futures curve. This causes losses to the SVXY fund from two sources: 1) from losses on the short outright VIX futures and 2) from losses stemming from the fact it is always buying a relatively high futures price and selling a low one. Both sources cause permanent shocks to the funds assets, causing it to buy back the overall number of futures contracts it is short REGARDLESS OF THE NUMBER OF SHARES OUTSTANDING. That is the important part, because now the VIX futures market can completely reverse the up move and SVXY will NOT return to unchanged (because it lost money with a bigger position than it has when making money, classically bad trading), it will have experienced a permanent shock downward until more investors pay a premium for it and increase the number of shares outstanding.

    UVXY has a similar mechanism but in the opposite price directions (due to its construction as a long vol etf) and its leveraged long nature. The accumulation of these factors can drag down both ETFs, even though on the surface they should hedge one another.

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    • The traders that make markets in SVXY options are aware of the dangers in offering OTM puts, but they have to balance the fact that there is a lot of money to make selling them during normal markets. you will notice that during periods of calm, market makers offer OTM SVXY puts in the 60-90% implied vol range. This is when the best opportunities exist in SVXY puts. Remember, you will have a negative theta drift waiting for the market to decline. The key is to pay as little as possible for the puts while you wait because without a decline you will bleed money. Thats why its important to purchase puts with IV’s closer to 70-80%. When SVXY goes down, it goes down hard (10-20 points at a time) so you can keep your costs down with way OTM puts. It can be good to use put spreads until you are certain of a vol spike; this covers your theta decay somewhat. then you can remove the short put hedge when you’re sure a decline is imminent.

      During market volatility (such as we just experienced the last two weeks) the IV spikes to 200% and above and its very expensive to establish a position in SVXY. This means you either have to stay perpetually long cheap puts or engage in a strategy that hedges your upside risk while you wait. The market considers an SVXY bankruptcy to be a “known unknown” so to speak so it is partially baked into every options price, thats why you can’t just buy a long-date OTM put and wait for the market to tank. Its best to wait and watch for the first sign of turbulence and pile on the puts, knowing that you will bleed money with a high probability until there is a significant decline

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