Understanding VIX ETPS
By Mark Sebastian, OptionPit.com
The Volatility Index (VIX) and its corresponding VIX futures are one of the most successful futures products created in the last 20 years. On any given day the VIX futures can trade 100,000 contracts. On a busy day the VIX futures might trade as many as 300,000 contracts. This is greater than almost any of the grain contracts, and just about every other future that isn’t the S&P 500 or directly related to U.S. treasury rates.
All successful futures products end up with equity like ETPs (exchange traded products) that attempt to follow the directional path of the future in a product that trades on an exchange. In the bonds, there is IEF and TLT, and if one wants to play an inverse ETP there is TBT. In corn and soy beans there is the CORN ETP and the SOYB ETP, while oil has USO. In the S&P 500, they might not say it, but really the SPY is just an equity version of the S&P 500 future. Thus, with how successful the VIX futures are, it just makes sense that the VIX futures would see a bunch of VIX ETPs introduced.
In the last 7 years, there have been almost 50 VIX ETPs launched, and about 7 or 8 that have stuck. Not a bad number considering that corn and soy futures have managed to have only 1 successful ETP. However, unlike some of the major futures-based ETPs, VIX ETPs have some unique characteristics that make them extremely effective in certain circumstances and utterly awful tracking ETPs in many other circumstances.
How does a VIX ETP Work?
Generally speaking, a VIX ETP has two major pieces in its mandate: term and tracking goal. In other words, what type of duration does the product attempt to track? There are short term futures products that track a future with 30 days to expiration and there are also products that attempt to track longer-term futures. In the case of a 30-day future ETP, the product attempts to track a position that holds futures with a constant duration of 30 days. Thus, today the ETPs futures holding will have 30 days to expire, tomorrow the ETP will have 30 days to expire, and in two months the ETP will have 30 days to expire. This attempt to hold duration will end up being one of the major keys to trading VIX ETPs.
The next key to ETPs is the tracking goal. There are products that attempt to track a long position in the VIX futures and there are products that attempt to recreate a short position in the VIX futures. Generally, one issue with the short ETPs and levered long ETPs is that they have a daily tracking goal, whereas the long futures do not have a daily tracking issue. On the other hand, there are a whole host of other tracking issues with the long futures position.
Here is the list of the major VIX ETPs with their durations and goals:
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All ETPs have an underlying index they attempt to track. VXX, for instance, has a long-term index that it tracks that is, other than being based on the VIX futures and being less well known, very similar to the S&P 500. Long ETPs track a long VIX index, while short and levered ETPs track a short index, usually with daily tracking.
In order to track the futures position goal in the prospectus, the VIX ETP must hold a basket of futures. For example in the case of VXX, if one contract has 15 days to expire and the next contract has 45 days to expire the basket held by VXX will be about 50% the front month future and 50% the second month future. The next day the portfolio will rebalance selling out of some of its holdings in the front month contract and buying contracts in the second. The following day the ETP will sell even more of the front month and buy the back month. When the back-month contract has 30 days to expire VXX will hold only the second month contract (which is now the front month). This process of selling one contract and buying another is called rolling. The VIX ETPs are not the only ETPs that engage in this behavior; however, no other product is driven by rolling than the VIX ETPs.
Daily tracking also engages in daily rolling. However, because it attempts to have a daily track rather than a long term track, the required rolling in the contracts tends to produce tracking errors. Therefore, the index XIV (the daily inverse of VXX) tends to veer from its index more greatly than VXX veers from its index.
The performance of the VIX ETPs
The performance of the VIX ETPs since inception varies widely, however they fall in two very different camps: the longs and the shorts. At the time of writing this the book, the VXX ETP is trading about 26.50 a share.
Just over $107,000 dollars a share!
VXX as a buy and hold product is quite possibly the greatest destroyer of wealth every created by the financial firms…at least until UVXY was created. UVXY puts VXX to shame at its split adjusted IPO price of over $35 million. Here is the chart of VXX over its history:
That being said, the ETPs do what they say they will do: they track the underlying index. If the VIX rallies, VXX will, for the day, track the movement of a portfolio that holds a VIX futures position with duration of 30 days. UVXY does exactly the same. Thus if one thinks that a basket of VIX futures will rally from one day to the next, VXX, VIXY, UVXY, TVIX, and VXZ will rally.
Why does VXX and UVXY lose so much? The answer lies, essentially, in rolling. Take a look at this picture of VIX futures and the VIX cash index:
The VIX future eventually has to converge to the VIX cash index settle (the VRO). Thus, if I buy a VIX basket of VIX futures with 30 days to expire (VXX), I am buying VIX futures in November for 11.40 and December for 12.30. As time passes, if the VIX stays around 10, my November futures are going to have to converge toward 10 and my December futures will converge toward November, before converging toward the cash itself. Thus, I am buying VIX futures for 11.40 and 12.30 and selling them back at less expensive prices OR watching my holdings lose every day.
For instance, if in the above example the November future had 15 days and the December 45 days to expire. At 10 and 40 days to expire, what will the value of my portfolio be if VIX is still around 10? Invariably the November futures that I have to liquidate to keep duration constant (the roll) will have been sold at worse prices than what they were purchased for. Additionally, my longer duration futures will likely lose value over the holding period as well. Thus, over a few days, the slow march from 12.3 in December and 11.40 in November down to 10 at expiration will kill VXX overtime.
One way to visualize this that is CLOSE to correct but not technically how the index works, is to calculate “roll yield”. To calculate roll yield I simply subtract the difference between the front month future and the back month future (12.30-11.40), then divide that number by the value of December. In this case the roll yield is (12.30-11.40)/12.30, or 7.31%. Roll yield will give the trader a back of the envelope calculation of how much VXX should lose over a 30 day period of time, all other things being equal (less the management fee in the ETP). Below see an illustration of how one would calculate and visualize how VXX roll yield works:
For the inverse ETNs the opposite action occurs. Instead of roll yield working in the face of the products performance, the roll yield works as the wind at the ETPs back. Names like XIV and SVXY have a tendency to just keep going higher. The daily calculation and management fee will cause the ETP to make less than the roll yield. In addition, because of the daily roll issue, these ETPs can lose A LOT of money fast. Here is a long-term chart of XIV:
In the last few years, the move higher has been astronomically fast. However, take a look at the percentage drop XIV took in August of 2015. XIV dropped nearly 50% in about 2 days. Thus, while XIV is around 140 at the time this is being written, it could drop to 70 or even 50 in only a few days.
Making Money Trading ETPs
It is important to read the prospectus of all the VIX ETPs. Understanding how these products work is important to understanding the risk associated with VIX ETPs. For instance, in XIV, if the VIX futures ever rally more than 80%, XIV can (and might) liquidate itself. This would lock in any loss that may have occurred with the future purchase. In VXX, the note that creates the VXX ETP is about to mature. Thus, after 2019, there will have to be a new VXX, with a new symbol, and a new note that traders will be able to swap on exchanges (thus the term Exchange Traded Note). These are two of the many intricacies related to trading VIX ETPs.
That being said, here is a basic approach to trading the VIX ETPs in a quasi-“buy and hold” approach. Generally speaking this can be done with inverse ETPs: XIV, SVXY, and ZIV. ZIV is by far the most stable as it is a medium duration product that is short months 4 to 7. Take a look at the performance of this product since inception:
The worst draw down since inception was in August of 2015 and was “only” 30%. If one was looking for the closest thing to “buy it and forget about it”, ZIV would be the product to hold. However, even with this relatively smooth run of things, we would add this risk management approach to a ZIV hold: when the 5th month gets more expensive than the 7th month, go to cash or cut the position down to a bare bones holding. If you are worried about a quick reversion to the mean, buy puts in VXX or VXZ as both trade options. This approach will smooth out the returns and hedge against a total loss in the product; however, it could cost the investor raw returns. Generally, our rule to get back in is not to do so until month 5 falls back below month 7 for at least 2 days and preferably a week.
Taking this approach WILL reduce returns, but will capture most of the upside of the inverse ETNs while reducing most of the risk of total loss. If we had an overnight explosion…yes ZIV could blow up, however, we have never seen that type of price action. Even in 1987 the price action needed to kill ZIV likely would not have happened.
A more aggressive approach but similar is to do the same with XIV:
As XIV is more volatile than ZIV, but also has high returns one should expect more volatility in a holding. To manage XIV, we like dumping the ETP when the 1st month trades above the 2nd month for more than one day. Then when the front month falls below the back month, again for more than 3 days, reinvest in XIV. Like our ZIV approach, this strategy to XIV will reduce returns, but will also reduce risk in the portfolio. Let’s take a look at a brief example in XIV.
In August of 2015, the VIX futures flattened up for a full day on Thursday, August 20th.
If one closed an XIV position upon this flattening, the trader would have been out of XIV at about 43.00 a share. XIV would be below 25 by the beginning of the following week. The investor would have been back in on October 12th at a price of around 29-30 a share. Thus the trader does not buy the bottom, but avoids all by 10% of the draw down in XIV.
More advanced approaches
Our favorite approach to trading the VIX ETPs involves trading options in VXX, UVXY or SVXY. We are not going to dig into these approaches as they involve:
- Strong understanding of options
- Strong understanding of the VIX index
- Strong understanding of the VIX ETPs
However, be aware that there are ways to use options to produce risk adjusted returns that dwarf being long XIV and/or long ZIV.
Hopefully, by now you understand that the VIX, while complex, presents the investor with a multitude of opportunity to invest and make money. While no holding is risk free, by engaging in risk management practice traders can produce a portfolio that can outperform standard equity investments and have a lower volatility of returns. If you would like to learn more, reach out to us: firstname.lastname@example.org .
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