The iPath S&amp ETN shares, which are constituted as debt instruments, can be bought and traded just like stock. The value of VXX shares often rises during periods of extreme stock market volatility. Quiet periods in the market, on the other hand, are likely to keep shares heading lower. This is why.
By CFE
Volatility has emerged as an asset class over the last decade, with VIX Futures leading the way. In 2004, the CBOE Volatility Index (VIX) was used to launch financial futures trading. This was the first time a publicly traded derivative that allowed investors direct exposure to projected market volatility was accessible for trading. If you’re thinking about adding volatility to your trading and portfolio management toolbox, there are a few things to keep in mind before you get started.
What Does the CBOE Volatility Index (VIX) Indicate?
VIX is a standardized measure of near-term volatility based on option pricing for the S&P 500 (SPX).
The VIX is calculated using two separate expiration sets of SPX options, with the two series being time weighted to produce a consistent 30-day measure of implied volatility.
When the S&P 500 is under pressure, the demand for SPX put options rises, causing VIX to rise.
Because of the heightened demand for portfolio protection when the market is under pressure, VIX has earned the moniker “The Fear Index.”
2. The VIX Index and the S&P 500 Index
Traders have been trained to believe that when the S&P 500 falls, VIX increases, and when the S&P 500 rises, VIX falls. This view has some merit because the long-term daily price change connection between the S&P 500 and VIX is extremely close to -0.75. On occasion, though, both the S&P 500 and the VIX move in the same direction. In fact, VIX and the S&P 500 price moves move in the same direction on around 20% of trading days. From January 2004 through July 2016, the table below shows the link between VIX and the S&P 500 on days when equities were higher and days when they were lower.
From August 2015 to July 2016, the daily price action in the S&P 500 and VIX is seen in the chart below.
There have been a few instances where the S&P 500 has dropped off sharply, and VIX has surged in reaction.
Contract Specifications for VIX Futures
A VIX Futures contract has a notional value of $1000 times the index. Futures trade in 0.05 or ($50 a tick) increments, but calendar spreads may be quoted in 0.01 ($10 a tick) intervals. In June 2014, the trading hours for VIX Futures were extended to nearly 24 hours a day, five days a week. Spot VIX is calculated and quoted outside of US trading hours, starting at 2:15 a.m. Chicago time, which is when European markets open.
The CBOE Futures Exchange has been listing VIX Futures expiring each week for multiple weeks in a row for just over a year.
There are also regular VIX Futures contracts that expire every month.
Standard expiration is usually on a Wednesday, which is 30-days before the standard third Friday SPX option expiration date the following month.
The VIX futures quotes from August 15, 2016 are shown in Figure 2.
VIX Weeklys Futures and regular VIX futures are used in the above quotes.
The VIX/Q6 contract is the typical VIX contract for August.
The quotes that start with a number are VIX Weekly Futures, and the numbers denote the week in which these contracts expire.
VIX futures are contracts that are settled in the morning.
The final settlement value for VIX Futures is the VIX Index’s Special Opening Quotation (SOQ). The SOQ is derived from the opening prices of constituent SPX or SPX Weeklys options that expire 30 days following the VIX expiration date. The ticker VRO is used to communicate the final settlement value for VIX futures. The day before settlement is the last trading day for VIX Futures, thus a contract that is set to expire on Wednesday morning will stop trading at 3:15 p.m. Chicago time the day before settlement. This means that on the day of settlement, a contract slated to expire will not trade during non-US hours.
Spot VIX and other VIX futures may trade at a premium or discount to VIX Futures contracts.
The majority of trading days, VIX Futures are trading at a premium to spot VIX as well as futures contracts that expire before the particular contract’s expiration date.
The pricing of spot VIX and regular VIX futures contracts on the Friday before and after the recent Brexit vote is shown in Figure 3.
RISK DISCLAIMER: Trading futures products carries high risk of loss, which must be acknowledged before trading and may not be suitable for all investors. Actual trades or methods referenced above may have performed well in the past, but this does not guarantee that they will perform well in the future. Phillip Capital Inc. bears no responsibility for errors or omissions in the material included herein, which is supplied to you solely for informational purposes and is believed to have been derived from reliable sources but cannot be guaranteed. The author’s thoughts and opinions in this letter are his or her own and do not reflect those of Phillip Capital Inc. or its employees.
What does it mean to short the VIX?
- Its value tended to rise during severe market downturns, earning it the moniker “Fear Index.”
- For those who shorted it (shorting is a bet that an investment will drop in price thus if you short the VIX, you win money when it goes down and lose money when it goes up), it was a major source of riches. The VIX was so popular as a trade that it even has its own subreddit.
Then, in February 2018, investors in XIV, SVXY, and other short VIX funds experienced this over the course of just a few trading days (XIV was the most popular ETF, or exchange-traded fund, that shorted VIX futures) GG.
Investors in XIV (which was forced to liquidate), SVXY, and other short VIX investment funds lost almost everything in a matter of days (meanwhile SPY, a fund that tracks the S&P 500, lost a mere 5.5 percent ). In today’s piece, we’ll look at why funds like XIV tanked so badly, and how it serves as a cautionary tale about avoiding placing all your eggs in one basket (especially if you don’t fully comprehend the risks).
Is it possible to short VIX futures?
Scratching the surface of most people’s knowledge generally reveals a lack of depth rather than depth. Former Democratic presidential hopefuls Tom Steyer and Amy Klobuchar both failed to name Mexico’s president, who is one of the most important counterparts for any US president. When US citizens are asked where well-known tourist sites such as Italy or long-standing political opponents such as Iran are located on a world map, the responses are fairly embarrassing.
Similarly, most investors are familiar with the VIX since it is constantly mentioned in the financial press, but few bother to learn how it is computed. For the vast majority of traders, it just displays the fear index, which is neither accurate nor useful.
Given that the VIX has recently traded at levels close to those seen during the global financial crisis in 2008-2009, investors are likely to believe that market mood is at an all-time high. Some investors have noticed that the VIX has recently mean-reverted and are considering shorting the index.
We will look at shorting the VIX from both a theoretical and practical standpoint in this research note.
Although the exact computation is extremely complex, the VIX gauges the implied volatility of 30-day options on the S&P 500. The variance risk can be explained by investors paying a premium for options to hedge their portfolios, as implied volatility tends to be higher than realized volatility. Regardless of these well-known variations, the patterns are nearly same in both.
The VIX hit an all-time high in March 2020, surpassing the previous peak set during the global financial crisis. These peaks appear to have been very sharp in the past, with implied volatility soon returning to previous levels. This has been attributed in recent years to central banks reacting quickly to market volatility and aggressively supporting these markets through quantitative easing programs.
Most central banks are required to regulate inflation, while a new generation of investors who began trading after 2008 may assume that preventing stock market crashes is also a priority. Modern central bankers have been chastised for being overly concerned with stock market performance; nonetheless, they are under enormous political pressure, particularly the chairman of the US Federal Reserve, given the president’s outspokenness.
Naturally, when trading at high levels, investors can take advantage of this link by betting on volatility to mean-revert.
Shorting the VIX when volatility is unusually high compared to previous history and exiting after mean-reversion has set in, as assessed by z-scores, is a systematic, theoretical model. The quantity of assumptions required to define such a trading strategy is a hurdle. We must define z-scores for entry and exit, lookback periods, trading expenses, and implementation, among other things.
To avoid overfitting, we’ll build two simple situations that merely change the lookback period. The entry z-score is set to 4, resulting in only a few transactions each year, the exit z-score is set to 0, and we trade on one-day delayed signals. The goal is to profit from the VIX’s short-term mean-reversion features.
Between 1993 and 2020, both scenarios had fairly comparable performance profiles, although there were some significant differences. The most notable was in February 2018, when the VIX soared by more than 100% in a single day as stock markets fell owing to fears that the US Federal Reserve will raise interest rates. The scenario with a shorter lookback erased all previous profits dating back to 1993, whereas the scenario with a longer lookback gained when the short position was entered a few days later.
The VIX’s sensitivity to the lookback period in these two seemingly simple cases underscores the difficulty of dealing with it as a time series. It also emphasizes the risk of shorting a financial instrument, which can double its value in a single day, which is extremely uncommon for practically all assets, with the exception of equities being purchased. A tiny asteroid on a collision course with Earth or a minor alien invasion are both far worse disasters for humanity than a pandemic.
Even if a skilled quantitative developer could find a reliable model to economically exploit the VIX’s mean-reversion features, there are numerous reasons why this might not be the best strategy for most investors.
Investors who use a short-volatility trading technique must act when stock markets are normally volatile. There have been times when volatility was high and stock markets fared well, such as during the technology stock boom in 1999, but volatility usually rises when stocks fall.
Given the positive correlation between volatility and negative stock market returns on average, applying such a strategy necessitates investors allocating capital when their equities portfolio would suffer a big loss, which is emotionally difficult for most investors.
Furthermore, volatility tends to congregate and typically persists at high levels. In the past, such a trading technique would have resulted in severe losses. Few investors have the fortitude to stick to a strategy that routinely has drawdowns of more than 50%.
The CBOE’s VIX data is only available from 1993 onwards, a period of little less than 30 years. The VIX only broke 50 twice throughout this time period, once in 2008 when Lehman Brothers announced bankruptcy and again in 2020 during the Coronavirus epidemic. We notice that the VIX always immediately mean-reverted to levels below 20 over this time period.
However, we may use realized volatility as a proxy for implied volatility and extend the observation period to 90 years of financial history by using realized volatility as a proxy for implied volatility. We note that volatility remained extraordinarily high for years throughout the Great Depression of the 1930s, making a short-volatility mean-reversion approach undesirable.
It would have been easy to claim a few years ago that volatility would not remain high for long periods of time, given the presence of experienced central bankers who studied financial history in order to avoid prior monetary blunders, such as those committed during the Great Depression.
However, most traditional tools in central banks’ arsenals have already been exhausted, forcing them to invent new ones. There’s a chance they’ll be unsuccessful, and volatility will remain high for years, as it has in the past.
Even if an investor could endure allocating capital when volatility is high and survive through the severe drawdowns, the short-volatility mean-reversion approach would be difficult to apply because the VIX is not a tradable index. VIX futures and options are available, but they come with their own set of complexities, such as roll yield and time decay.
Over the years, asset managers have introduced a variety of VIX-related products, but none have been able to properly reproduce it. Given the repeated central bank interventions that generated the buy-the-dip mentality during the global financial crisis, shorting volatility became a popular strategy. Volatility surged on occasion, causing the collapse of some short-volatility instruments like XIV in February 2018.
ProShares’ Short VIX Short-Term Futures ETF (SVXY), which provides inverse exposure to short-term VIX futures and has about $650 million in assets under management, is the most popular instrument for shorting volatility available today. Despite the fact that the ETF was not liquidated in 2018, it had a drawdown of more than 90%. After that, SVXY reduced its leverage to 0.5, however, like most inverse ETFs, it rebalances daily, which can swiftly destroy value due to negative compounding. Shorting the iPath Series B S&P 500 VIX Short Term Futures ETN (VXX), which provides long exposure to short-term VIX futures, is another option.
When SVXY or a short position in VXX is compared to theoretically shorting the VIX, the results are dramatically different. From 2011 through 2019, the VIX fell, albeit with negative skewness due to dramatic rises and slower decreases. When computing a potential short position in the VIX, this results in a severely negative performance due to compounding. SVXY, on the other hand, has produced substantial returns since 2011, but with significant drawdowns that have wiped out almost all of the earlier gains.
When employing the VIX as a time series in volatility trading methods, investors should keep in mind that the various financial products will perform very differently than the index.
Inverse ETFs, in particular, should be approached with caution because they provide the desired short exposure on a daily basis, but due to compounding mechanics, this does not imply a similar performance over longer time periods.
Investors can learn a lot by looking at the VIX since it pushes them to think about the impact of a shift in volatility on their portfolios. Unfortunately, most asset classes and strategies have little volatility in one direction. A favorable market climate benefits developed and emerging market equities, corporate and high yield bonds, private equity, venture capital, and most other assets. When the global economy is about to enter a recession, none of these gain in value, which is shown in rising correlations during crisis moments.
When volatility is increasing or elevated, few asset classes or strategies profit, but they tend to produce the most diversification benefits and are thus highly important in any asset allocation framework, even if only as a satellite position. Unfortunately, these are notoriously difficult for investors to hold because they do not behave like the rest of the portfolio in normal times and are thus continuously tested. The adversary, as usual, is ourselves.
What is the term structure of VIX futures?
VIX is the S&P 500’s ‘implied’ 30-day volatility generated from call and put options. It depicts the S&P 500’s likely range of movement in the near future, both above and below its current level. Take the VIX close on Wednesday, March 25th, 2020 as an example; the number 63.68 indicates that there is a 68 percent possibility that the S&P 500 will trade within a range of +-18.4 percent (equal to +-63.68 percent annualized) from where it is now over the next 30 days. Based on Wednesday’s close of 2475, this translates to a range of 2020 to 2930 in terms of levels.
The link between VIX futures prices and maturity dates is known as the term structure. When VIX futures are priced higher than the VIX spot, it is said to be in Contango, and when the relationship is reversed, it is said to be in Backwardation. The term structure curve for both Contango and Backwardation can be either concave up or concave down, depending on whether the mid-term futures prices are closer to the short-term or long-term prices.
The stock market was completely oblivious of the impending catastrophe in January and early February. The VIX began the year at 13.78, with a classic Contango and concave down term structure. The VIX spot was slightly elevated to 17.97 on February 3 when the coronavirus outbreak hit China, owing to fears of supply chain disruptions and a global economic slowdown, but the VIX term structure was nearly flat (green line in the chart below), indicating that the market wasn’t overly concerned. On February 19, 2020, the curve reverted to its original configuration. (Note that all three curves have a jump in the back end since VIX futures prices are higher around the presidential election.)
Then, on February 20, the selling began. As VIX surged and moved ahead of futures prices from February 21 to 28, the term structure of the VIX soon shifted from Contango to Backwardation. However, the increases were minor and concentrated at the front end (the cluster in the figure below), indicating that investors believed the occurrence would be a one-time blip.
Major indices had had their fastest declines in history as of March. On March 16, the VIX reached an all-time high of 81. Its term structure was severely backwardated, and all futures prices rose over the time horizon (blue line in the chart above). The message it was sending was that the stock market may be all over the place in the near term, with the S&P 500’s range of movement as large as +-32 percent annualized even 6 months out (180 days).
The VIX futures curve moved from concave up to concave down (black line to green line in the image below) in Backwardation from March 16 to 23, as the front end declined with the spot, but the mid and back ends remained the same. During the financial crisis on October 16, 2008, the 30-day to 90-day futures were priced substantially lower relative to the VIX spot (blue line). This concave downward form suggests that it will be some time before VIX drops below 40, and that uncertainty will linger in the stock market for longer than was projected on that specific day in 2008.
VIX and its term structure, like the stock market itself, vary on a daily, if not hourly, basis. Investors update their thoughts and expectations on where the market is headed as new information becomes available.
Is it time to buy when the VIX is high?
“If the VIX is high, buy” indicates that market participants are overly negative and implied volatility has reached its limit. This indicates that the market will most likely turn bullish, with implied volatility returning to the mean. The greatest option strategy is to be delta positive and vega negative, which means that short puts are the best alternative. Positive delta just means that if stock prices climb, so does the option price, and negative delta simply means that a position gains from lowering implied volatility.
What does a normal VIX value look like?
The VIX tries to predict future volatility for the next 30 days, but it isn’t very accurate. A VIX of 25 does not always imply that volatility will average 25% over the next month or so. According to studies, the VIX tends to overestimate volatility by 4 or 5 percent on average. However, research have shown that the VIX has some predictive validity. Here are some basic rules for interpreting the VIX level in terms of future volatility:
- When the VIX is between 0 and 12, volatility is predicted to be minimal. In November 2017, the VIX had its lowest daily closing value of 9.14.
- VIX 13-19: This range is considered normal, and volatility over the next 30 days is predicted to be normal when the VIX is at this level.
- When the VIX reaches 20 or higher, you can expect higher volatility than usual over the next 30 days. This level is usually reached during periods of market stress, such as when fears of an economic downturn or recession are present. The VIX can reach 50 or higher during major market shocks like the financial crisis or the emergence of a global epidemic.
Unexpected occurrences can throw markets for a loop, and a low VIX number today could be followed by a period of significant volatility if conditions shift.
What exactly does a VIX of 30 imply?
The Cboe Volatility Index (VIX) is generally known as the “Worry Index” because it measures the level of fear or stress in the stock market using the S&P 500 index as a proxy for the entire market. The higher the VIX, the more fear and uncertainty there is in the market, with levels exceeding 30 signaling extreme fear and uncertainty.
Is it wise to invest in SVXY?
The index has fallen in 73 percent of all months during the last ten years, with the likelihood of losses growing as the holding period lengthens. Simply put, for the vast majority of traders, this index has not been a profitable investment over time.
And this is where SVXY’s attraction comes into play. It’s a half-leveraged ETF that’s shorting this index. Shouldn’t an ETF that shorts something that falls almost all of the time be a good trade? Not so fast, my friend. Before we trade this relationship, we need to figure out exactly what’s driving it, and then we need to talk about the risks of shorting anything tied to the VIX.
When it comes to trading VIX futures, the biggest issue is that they are usually priced higher than the VIX itself. This means that in 85 percent of trading days over the last ten years, the front-month VIX futures contract has been higher than the VIX spot level.
The fact that futures eventually converge or attain parity with spot prices is why this pricing disparity is such a major issue. In other words, if you own a futures contract that is priced higher than the spot market, you will face some relative losses when your contract approaches spot pricing as expiration approaches.
The extent of the disparity between the spot market and VIX contracts is what makes VIX futures so bothersome. The current VIX market and forward curve, for example, as supplied by CBOE:
Is it possible to sell VIX calls?
Although selling VIX calls can be dangerous, selling VIX puts isn’t always a risky move. The index can’t fall below zero, and it only trades below ten times a year. Also, because the options are cash-settled, you won’t have to worry about being short when they expire.