How Not To Trade Volatility ETPs

| About: iPath S&P (VXX)

I have seen articles here and there that say the right time to buy long volatility ETPs like VXX or UVXY is when VIX is low, and the time to short them is when VIX is high. This, to me, is dangerous advice, and I decided to show it with some analysis.

A picture, as they say, is worth a thousand data points.

So, what does the above chart represent? Before I go into that, I would like to ask you, dear reader, whether you see any pattern in these two charts, or if it seems like a completely random jumble of data points. If you answered yes to the latter, you would be right.

I downloaded VXX daily returns for all of its existence. I then calculated 5- and 10-day returns for each trading day. Finally, I pulled the VIX values for the same days.

Then I plotted them.

So what do these above charts tell you? They tell you that as VIX changes, VXX also changes, but completely randomly. At low VIX values, VXX is just as likely to go up as it is down, and the same is true for high VIX values. The absolute level of VIX is, well, absolutely uncorrelated to weekly or bi-weekly changes to VXX (as it will be for its 2x leveraged cousin, UVXY). Statistically speaking, the R2 values at 0.01% and 0.04% mean that, well, VIX has absolutely no predictive power when it comes to predicting the trend for VXX or UVXY.

Just as a sanity check, I also calculated the correlation coefficient between VIX daily values and the 5- and 10-day return for VXX from that day. The correlation coefficients are -1% and +2% respectively. For two variables that are completely uncorrelated, hence one can't be used to predict the other, the correlation coefficient is 0. Well, with real life data, -1% and +2% is as close to 0 that you can get.

However, the charts also show another thing. On average, over a week VXX is going to lose ~1.4%, and over two weeks ~4.1%. Hence, while the level of volatility cannot be used to predict when to short VXX, you can short VXX pretty much any day of the week at whatever level of VIX, and odds are you will come out a winner.

By the same token, if you buy VXX or UVXY when VIX is low (as now, for example), chances are you will likely lose money as well. This doesn't mean it is guaranteed to lose money. It just means on average it will lose money.

So what would happen if you used VIX values to trade VXX or UVXY? Well, you will sometimes have a loss and sometimes a gain, in a completely unpredictable manner. I would like to hear from active VXX or UVXY traders who trade these based on VIX values on what their experience has been.

So, if the VIX levels cannot be used to trade VXX or UVXY, what can? The answer, of course, are the contango (backwardation) levels in the VIX futures term structure. The higher the contango (backwardation) the more these two ETPs are going to go down (up). The absolute level of VIX is pure noise and should be ignored.

However, before I conclude, I have decided to share one little nugget about these ETPs.

Day Average daily drop for VXX
Monday -0.32%
Tuesday -0.07%
Wednesday -0.45%
Thursday -0.31%
Friday -0.53%

Over its lifetime, VXX tends to drop, on average, the most on Fridays, and the least on Tuesdays. I have no idea if the drop on Tuesday is completely random, but there is actually a good reason for VXX to drop on Friday. It is not a guarantee, and market conditions override, but VIX has a tendency to drop on Fridays. This is because people hedging their portfolios with S&P500 options don't want to pay for the time decay over the weekend, so sell some part or all of their hedges on Friday, and buy back on Monday. As VIX drops on such select Fridays, the VIX futures drop along with it, and so does VXX and UVXY.

However, I am not sure if this is statistically significant. I think trying to time VXX or UVXY longs and shorts is a folly. The best thing to do is to look at the term structure, estimate where it will likely end given macroeconomic conditions (more an art than science), and then buy the appropriate puts and hold. These ETPs are designed to drop, and drop they do, despite sometime spikes like today (8/6/13).

Disclosure: I am short VXX, UVXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I hold puts, not outright shorts.

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