This article is written to highlight a profitable, long term, market neutral way to exploit inefficiencies in ETNs that track VIX futures. In this case, we will be betting an inverse ETF against a long ETF, both tracking short-term VIX futures.
The dollar-for-dollar payoff of holding (NYSEARCA:VXX) against (NASDAQ:XIV) is stacked above the VIX chart in the graphic below: (Note: Long 16 shares of XIV against 1 share VXX, when VXX was $160 and XIV was $10, dollar-for-dollar, taking into account splits.)
What can be drawn from this basic example? The VIX may be range-bound and mean-reverting, but the payoff from playing these two ETNs against each other has an upward trend, and in this case, pays well if you enter during a volatility spike. As this graphic clearly illustrates, the most desirable time to enter this dollar-for-dollar trade is when the VIX begins to rise above its mean. The mean for the past five years is 17.35.
One should have a target entry level based on the density function of the VIX. One could infer that when the VIX is at or above 25, this type of trade is desirable to step into. If one entered the position in August of 2011, you would have made approximately $200 on a single position over the course of a year.
This is a simple position where you are taking advantage of the inefficiency of each ETN rolling over futures contracts each month. If you step into a trade like this, you will be exiting with a nice profit within 6-12 months.
Right now is NOT the best time to pull the trigger on a trade like this given the low levels of implied volatility, but as history repeats itself, when the VIX gets hot, do not feel hesitant to take this dollar-for-dollar approach to milking these two ETNs. As the VIX lifts, the weight of this position can increase (you have a better statistical edge).
MORAL OF THE STORY
If you take the time to compare the behavior of ETNs that track futures based products, you begin to see opportunities to make money when comparing them to similar products that are quasi-correlated. In this case, the dollar-for-dollar short VXX and long XIV appears to pay off particularly well when entering the trade when the VIX is above 25.
Do you want to put all your eggs in this position? No. But this is a high probability way to make money off those insuring their portfolios with ETN products. This is a position you can conservatively devote a small percent of trading capital (2-3%), which will profit from market neutrality and the inefficient nature of ETN products.