Over the past couple of months the Credit Suisse Inverse Volatility ETN(NASDAQ:XIV) has seen some sustained upward price action, and with it a tremendous surge in short interest.
If the comments I have been reading on Seeking Alpha are, at least in part, representative of the broader market, then this short interest is thoroughly misguided and will not end well. It seems that the primary rationale behind shorting XIV is "The VIX is at 12.70 - It can only go up from here." While this is a sentiment I would agree with, seeing the VIX has exhibited a strong tendency towards mean reversion in the past, I maintain that shorting XIV, or going long on VXX, TVIX or UVXY, for this reason is a spectacularly bad idea. In reality, this is a compelling reason not to short XIV or go long on pro VIX products.
Contago and Backwardation
Contrary to popular belief Volatility ETFs and ETNs do not directly track the VIX. A gain in the VIX will not necessarily produce a proportional gain in VXX or a proportional decline in XIV. In fact, it is entirely possible for the VIX to be up over a month and for XIV to be up as well. Below, you will find that is exactly what happened over the past two months. The VIX was up 7.67% but XIV, which theoretically should produce returns inversely proportional to that of the VIX, is up as well.
This is because VIX products buy or sell VIX futures contracts since there is no way to trade the VIX directly. In the case of XIV, it sells varying amounts of the front and second month contracts short.
Because of this, XIV experiences what is called roll yield, which can be positive or negative depending on whether the VIX term structure is in contango or backwardation. When the contracts are in contango, which has been true for some time now, they trade at a premium the current spot price. As the contracts near maturity they shed the premium, generating a positive roll yield for XIV and a negative yield for long VIX products such as VXX, TVIX and UVXY. The chart below displays the February, March and April contracts in relation to the spot VIX over the past two months.
(click to enlarge)
As you can see, the spot VIX is slightly higher over this period, but the performance of the futures contracts is a different story entirely. From February 1st to the 13th(when the Feb contract matured), the spot VIX declined only marginally. However, the February contract was down significantly, as it also had to shed its premium on top of the decline in the VIX. The spot VIX was actually up when the March contract matured, but once again the contact's price had fallen significantly. The performance of the April contract to date is following the same pattern.
This is why XIV, which rolls short positions on these contracts, has been performing well in spite of the VIX rising.
Historically, VIX futures have been in contango around 70% of the time and in backwardation 30%, most likely due to the insurance nature of these contracts. In particular, I have noticed that contango seems especially persistent when the VIX is depressed. To understand why, just put yourself in the shoes of a futures trader at the CBOE. Like you, he will be aware of VIX's tendency towards mean reversion, and will expect it to rise in the future.
Undoubtedly, the VIX will rise for it cannot remain at the depressed levels it has been hovering around the past few months forever. However, the question that remains is when? It could be in the next week or months from now, and in the meantime contango will continue to bolster XIV's value and whittle away at TVIX, UVXY and VXX.