VIX ETNs Show the Importance of Knowing What You Trade

Last week, I gave you my opinion on the new VIX ETNs. Basically, I think they’re suitable for only those who understand the behavior of the many different duration VIX futures contracts as compared to the VIX itself, are willing to accept uncertain tax consequences, and are willing to become unsecured creditors of Barclays (BCS).

The reason I have an update is because Bill Luby at VIX and More provided a graph that is pretty common in my world, but is not so common elsewhere. I doubt many of you have even heard the words “VIX term structure”. Yet the term structure of the VIX futures contracts is critical in understanding how these ETNs are going to work. That sets up a pretty ironic paradox. The new VIX ETN is meant to bring VIX hedging to individuals (institutions don’t need it, as they can get customized swaps or trade the futures). Yet individuals don’t understand the implications of what it is that they’d be buying.

[click to enlarge]

Like I said before, if you aren’t aware of the trading behavior of VIX futures – if you don’t understand the implications of Bill’s chart — don’t even think about trading the new ETNs.

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I got a call Friday from Murray Coleman at IndexUniverse. We talked about a variety of topics that eventually turned to the new VIX ETNs, which are based on the VIX futures. You can read the article here. We talked about how the new products are based on VIX futures. Murray told me how some studies say the “correlations” between VIX and the VIX futures were extremely high — 88%. I told him that the numbers are probably correct, but I didn’t monitor the correlation numbers that closely. Correlations tell me a little, but not everything you need to know. For instance, are the correlations constant over all market conditions? I then proceeded to give him some examples. Take a look at this table I prepared for the article:

This pretty much illustrates the point my fellow bloggers and I have said repeatedly. The VIX futures have more of a central tendency than VIX itself. And the consequences are: when VIX drop too fast, the futures don’t drop as much, and when VIX rises too fast, the VIX futures don’t climb nearly as much.

Take an especially close look at the numbers on September 10 and on September 29. The VIX went from 24.52 to 46.72 — a near double. The October futures moved up a bit — up from 24.31 to 32.69. The action in the November and December futures is comparatively minuscule; they barely budged. Now look at October 10. The VIX skyrocketed to 69.95. The October futures started to pick up because it was expiring soon. But November and December — those two contracts lagged so badly it was laughable. Now I ask you, what kind of correlation is that??

The biggest laugher of all, however, is what happened from mid-October to early-December. VIX was up near 70%. Let’s say that on October 10, you predicted that the high volatility levels were unsustainable and that index implied volatility would be lower at the beginning of December. You’d have been right. You probably would have gotten pretty nervous in mid-November, but eventually your forecast proved correct. But had you gone short VIX futures–or any ETN designed to track those futures–you would have gotten hammered, because the December futures skyrocketed from 33.79 to 57.93. You’d have been right about index option implied volatility, but you’d have gotten crushed because the volatility futures rose!

That’s what I mean by knowing what you trade. If you think these VIX ETNs are going to mimic the VIX, guess again. They’re going to mimic the futures. And as shown above, the futures and the index are two different things.

Yes, most of the time, the futures and the index track pretty closely — there’s an 88% correlation. Look at the numbers in the top few rows of the table. They’re almost identical. But 88% is not the same thing as 100%. And somehow, that other 12% pops up at the most inopportune time. For when volatility goes to an extreme, the tracking goes haywire at the precise time you need them.

Comments

[sbenard:]

Apparently, the symbol VXY was released as VXZ instead?

Feb 14 12:25 PM