Volatility ETFs like VXX and XIV are quite popular. But I often wonder whether the people trading them truly understand what they are buying and selling. I’m going to try to explain exactly what’s going on in these “volatility trading vehicles” in the hope that people aren’t blindsided by what actually drives the gains and losses.
The first thing to know is that the VXX is the long VIX short term futures ETF. The XIV is the short VIX short term futures ETF. What that means is on a (very) short term basis the VXX goes up when the VIX goes up (not the spot VIX, more on that in a bit), and goes down when the VIX goes down. The XIV goes down when the VIX is up, and goes up when the VIX is down. Again, this is is just the first step in keeping track of these and I’ve already taken a few short cuts.
These don’t actually track the VIX. The VIX is that number talked about on TV and written about in articles… THE FEAR GAUGE. It’s basically a formula taking into account a given range of options in the the SPX over the next 30 days. Here it is on the teevee right now:
But the VIX itself doesn’t trade. It’s just an index. I doesn’t trade because it’s mean reverting. Everytime it went up to 26 you could sell it, and every time it went to 12 you could buy it. Wait around and let it mean revert and you’d be rich. So they don’t do that. It’d be stuck at 19 forever. Because arbitrage.
So something that does trade is VIX futures. And this is what brings us back to VXX and XIV. Those track the first 2 month VIX futures, not the spot VIX itself. And because these ETFs track the futures, they need to continually roll from the front month to the next month so that their window (time frame) is always exactly the same. Therefore, over the long term their success and failure has much less to do with whether the VIX goes up or down, but what the daily difference between the first two months of the VIX futures looks like.
I’ve never traded futures professionally, I was an options market maker/specialist. But that could work in my favor here as I won’t get too technical with futures terms. But the two you do need to remember are contango and backwardation. Those are the terms used to describe whether the roll in futures on a daily basis is selling high and buying low or buying high and selling low.
Typically, the VIX futures are contango. What that means is everything is normal, stocks are trading without much volatility, the VIX is below its historical average, often as low as the low teens and the futures each month out increase slightly back towards the historical mean. So if the VIX was 13, you’d probably see something like front month futures 14, 2nd month 15, third month 16. What that means for the roll is that every day the VXX and the XIV need to roll that day’s share of futures from the front month (at 14) to the second month (at 15). Under this scenario, for the XIV that’s a great situation. Each day that ETF gets to cover short VIX front month futures for 14 and sell 1 month out VIX futures at 15.
But for the VXX contango is brutal. It has to sell at 14 and buy for 15 each day. That essentially means the VXX decays under normal market conditions each day while the XIV collects each day. This is why these 5 year charts look like this:
I don’t want to give the impression that these ETFs don’t move in a big way alongside big moves in the VIX. Look at the last few days in the XIV (short VIX futures) as it got cut in half when the market tanked and VIX futures spiked:
But here’s the thing about that move, what happens next in the futures curve is equally important. If we stay volatile from day to day and the roll stays in backwardation for weeks XIV will continue to get hit hard. At this time of the year in 2011 VIX futures stayed in backwardation for 4 months. XIV was down about 70% in that time period. During that same time period VXX tripled.
So since we’re in backwardation do you run out and buy VXX? Have a look at that chart 5 year chart again. VXX gets crushed once the futures go back into contango (which also corresponds with the futures themselves declining) So it’s a double whammy when it reverses. I wouldn’t ever recommend that kind of risk.
So the lesson here is to watch the futures curve as much as the VIX itself in these products. Longer term it’s more important for these products than any day to day move in the VIX.