$VMAX – Don’t Get Fooled Again

by CC May 5, 2016 3:08 pm • Commentary

A couple of new volatility products were just released. These are similar to what has come before with the VXX and XIV but instead focus on the weekly VIX futures. Here’s REX Shares founder Greg King explaining how they work to CNBC’s Dominic Chu:

I’ve written about “trading” the VIX several times in the past. The key to understanding these exchange traded VIX etfs is to understand just what it is you own or are shorting. Here’s a bit from my last post from August 2015 on the subject of VXX:

Typically, the VIX futures are in 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:

VXX 5 year chart from Yahoo Finance:

Screen Shot 2015-08-26 at 12.01.02 PM

XIV 5 year chart from Yahoo Finance:

Screen Shot 2015-08-26 at 12.01.28 PM

So let’s look at the new products through the same lens, particularly VMAX cuz that’s where the danger lies.

Greg King has a long history in exchange traded funds at Barclays and Velocity shares. One of his creations was the VXX that I mentioned above. With this new product he’s attempting to better track the VIX by moving the time frame up to the weekly futures. This should give investors better exposure to the spot VIX, just in that the weekly futures will move alongside the VIX each day in a much closer fashion than 1 month out futures. I discussed the product over email with Mike Khouw (Dan’s co-panelist on Options Action and author of The Options Edge) and he explained it this way:

I believe they want to capture more of the vol of vol than the existing products do. The front month future better replicates spot, the 2nd month future less so and so on, basically a play on a nearer-front end of the vol-cone spectrum, so instantaneously a 1 week future better replicates spot than a 1 month (crudely said, but hopefully I’m conveying the idea).

My concern is that in the marketing for VMAX that the sales pitch of a “better VIX tracker” glosses over that it has the same risks of decay as VXX does. Remember, no matter how close you track the spot VIX, the largest contributor over time to this product will be its daily roll during periods of contango.

For more on that subject, here’s more of my conversation with Mike:

Mike, am I thinking of this correctly that by using weeklies the cost of the roll is no different than monthly futures? just sped up? In other words instead of a worse roll spread out over 30 days you have a less worse roll playing out over 7 days on bigger portions of the roll each day? And giving you about the same contango problem that VXX has? Not that the math would be exactly the same but that over time would produce a similar money suck?

Mike responded:

Although I haven’t run the numbers, in a word, yes.

If that weren’t true a theoretical stat-arbitrage opportunity would exist, long this product, short conventional products or preferably long rolling 1 week, short rolling 1 month in contango markets and the opposite in backwardation (although that is a riskier proposition).

So the key point here is that yes, VMAX will better track the day to day gyrations of the spot VIX. But I’m not sure how much value there is to that if it produces the same money pit scenario that VXX had over time. Be careful out there.

For those looking to be “long” volatility we still prefer options trades in the VIX futures where you can take advantage of the asymmetry when the VIX is low by selling a slightly out of the money put in order to buy an upside call. We haven’t done one of those in a while but I’ll follow up at some point with an example of those trades. Hopefully with the VIX quite low and looking out a few months for a “long VIX” trade.