The morning of March 11, the VIX, a measure of market volatility, crashed below 12 to a 3-year low:
Since the VIX is one of those measures that have a habit of returning to its mean (about 20), this isn't going to last, that much is fairly certain. Is there a way to profit?
The answer turns out to be surprisingly complex.
The first problem is that the VIX itself isn't a tradable product, but simply an indicator. That means, one has to look for other instruments that are actually tradable to take a position.
There are plenty of these instruments:
- VIX futures
- VIX ETFs and ETNs
- VIX options
The most obvious investment would be in VIX futures. There are monthly futures, expiring on the third Wednesday of the month. These products are very liquid, but just taking a position in a single future involves a sizable sum of money. The April future contracts, trading at $14.70 per contract, represents an investment of $14,700.
You want to keep that in mind, especially since margin requirements are low, so the leverage you get is high, which could easily trip up the novice investor in taking on a position that's way too big for his own good.
A problem with these VIX futures is that they expire, and before doing that, they contain a good deal of time value. This creates two problems:
- You'll have to either close your position or roll it over in the next month futures, involving transaction cost
- Next month futures are usually more expensive (a situation known as 'contango'), compounding the cost of rolling over futures
To illustrate the first point, note that the March future is 13.50 at the moment while the VIX itself is at 11.70. That's an almost 2 point difference that is going to close before the March futures expire one way or another:
- Either the VIX itself moves up
- Or the VIX April future moves down
It could easily be a combination of both, but if the VIX keeps on falling, the implication is that the VIX March future will fall much more. Even with a stable VIX until the expiration of your March VIX future contract will lose you almost $2000 until then, or having to roll it over in April VIX futures (trading at $14.70 at the moment).
That isn't an easy decision to take if that happens, although, given the record low VIX, it's probably the best. The VIX will rise, that's almost guaranteed, we just don't know when. And until it does, investing in VIX futures can be rather frustrating and loss making:
- Seeing the time value evaporate out of your expiring VIX futures contracts
- Having to roll them over, involving transaction cost (and loss due to the spread, the difference between bid and ask)
- Having to roll them over into new future contracts, which still have a good deal of time value
You see, if the VIX doesn't move up sufficiently you can keep on losing in three different ways, repeatedly seeing time value evaporate out of expiring futures and having to roll them over into new futures with time value. Wash rinse, repeat, until the VIX rises.
If you think you're the only one with the problem we just described, think again. Popular VIX ETF products, like the iPath S&P 500 VIX ST Futures ETN (VXX), automatically roll over a portion of their futures contract from the expiring month into the next month. As we write this, the April VIX futures trade for $14.70, while the May VIX future contracts trade for $15.80, that's an $1100 difference per contract.
In a way, most of these VIX based ETFs (or ETNs) are automated loss machines as a consequence. If you don't believe us, here is the chart of the VXX, for instance. This really is a case of a picture telling more than a thousand words:
Only a fraction of this massive loss is caused by a lower VIX, the rest is just 'negative roll yield,' as those costs of rolling into higher priced futures under contango is called. These are not products to buy and hold, but they are products to short. Long term, you're almost certainly going to make a substantial profit from shorting, unless we're at the verge of a new and lasting explosion of volatility.
Because the one thing you have to realize, contango is only a reflection of expectations that the VIX will rise over time, and its possible for contango to reverse into what's called 'backwardation.' The latter describes the phenomenon that the near-term month VIX futures are cheaper than the longer dated VIX futures.
Backwardation is simply a reflection of the market expecting the VIX to fall, usually this happens when the VIX is way above its mean of about 20.7. However, as contango generates a negative roll yield, backwardation gives a positive roll yield and this results in an extra boost for VIX ETFs, especially those that are leveraged by a factor of 2 like ProShares Ultra VIX Short-Term Fut ETF (UVXY),VelocityShares Daily 2x VIX ST ETN (TVIX) or C-Tracks Citi Volatility Index TR ETN (CVOL).
Below is the graph for the VelocityShares Daily 2x VIX Short-Term ETN , a 2x leveraged VIX ETN.
As you can see, the upswing in July to October 2011 was particularly violent, moving from $150 to a peak of $1100 (the actual prices were $15 and $110, as the stock did a reverse split since). Part of it is the increase in the VIX itself, part of it is the 2x leverage, but part of it was the backwardation kicking into VIX futures when the VIX spiked way above its historical average.
You could take a position in these leveraged products, but the longer you have to wait for that near inevitable spike in the VIX, the more it is going to cost you in the meantime, and the bigger the spike has to be to recoup your money. That's certainly not impossible, as the above figure shows, but you need quite a bit of a spike in the VIX to be compensated for any intermediate losses.
The cruel thing is, contango can also be steep, especially if the VIX is very low and the market expects it to rise in the coming months. The steeper contango is, the bigger the negative roll yield, with leveraged ETNs like TVIX or UVXY, that will accumulate some serious losses the longer you have to wait for that spike in the VIX.
If you don't want to risk the negative roll yield of investing in VIX futures or ETFs (or ETNs, as it happens), but still want to position yourself for a spike in the VIX, perhaps options on these instruments is a good choice? There are options on:
- VIX futures
- VIX ETFs and ETNs
With futures, you can lose your shirt because of the leverage, but buying options limits your loss to what you invested. However, we cannot generally recommend options on VIX futures, due to their weird trading pattern and huge spread (issues that merit another post).
Options on VIX ETFs or ETNs, like VXX or UVXY trade a bit more decent, but can be very expensive due to implied volatility (especially of course the options on UVXY, which is leveraged ETF on the VIX), and you'll get the same kind of losses as the products themselves, only more so.
The sad conclusion has to be that there is no solid way to position yourself for an uptick in the VIX. All investment options suffer from significant decay, the more so the longer one has to wait for that uptick in the VIX. Is there anything we can do? Well, perhaps three ways are still open:
- Wait for an uptrend in volatility to emerge, especially if there is negative news that could do significant damage to equity values (like another installment of the euro crisis). If you catch it early, you're likely to win significantly.
- Write puts on a VIX ETF or ETN. This is somewhat scary if you do it uncovered, if the VIX keeps stable, you might have a forced buy above market price, but if you chose sufficiently far out of the money and with sufficient time to expiration, that risk isn't terribly high, unless the VIX keeps as low as it is until these options expire.
- There are VIX based ETNs and ETFs which are based on intermediate VIX futures, like VXZ, VIIZ or the leveraged TVIZ, where negative roll yield isn't so important, although the corollary of that is that these products show a muted reaction to changes in the VIX.
We've seen numerous volatility based ETFs and ETNs. However, none of these products seems to have really cracked the problem of negative roll yield if one wants to go long on the VIX. That seems to be a vexing, dare we say, vixing problem in urgent need of a vix, uh... fix.