Where Do Volatility ETPs Go From Here?

Includes: SVXY, UVXY, VXX, XIV
by: Macro Investor

So, it happened. The earnings season has winded down, and the August expiration is behind us.

I had written a series of articles in July predicting where volatility ETPs will land by August expiration. I took a look back at my forecasts, as I refine my predictions for September.

So, how did I do?

Here are my predictions from July that I wrote in article titled Volatility ETFs In A Free Fall: How To Profit.

VIX, today, ended at 14.37. Interpolating from my model, VXX should have ended around 15.6, UVXY around 40, SVXY around 104.7, and XIV around 26.6. The end values turned out to be 14.97, 36.73, 106.01, and 26.99 respectively. In other words, I underestimated both the drop in VXX and UVXY (long ETPs) and the gain in SVXY and XIV (short ETPs). The model, hence, was rather conservative.

Prediction Prediction Actual Expected Gap
VXX $ 15.2 $ 15.7 $ 15.0 $ 15.6 -3.9%
UVXY $ 37.9 $ 40.7 $ 36.7 $ 40.0 -8.1%
SVXY $ 105.7 $ 102.0 $ 106.0 $ 104.7 1.2%
XIV $ 26.9 $ 25.9 $ 27.0 $ 26.6 1.3%
VIX @ $ 14.0 $ 14.5 $ 14.4 $ 14.4

So, what explains the gap? The end values are not only dependent on the end VIX value, but the path that VIX takes as well, and in addition on the relative contango at each day. I modeled a flat, slow decrease in VIX and a slowly decreasing contango, which has not been the case. Excess volatility in VIX (i.e., the way VIX changed during this time, up and down instead of steadily down) and steeper contango than I expected throughout the time led to excess losses in the long volatility ETPs and excess gains in the short volatility ETPs. This is important to further calibrate my model when I use it in future. Aside from that the model did its job.

However, mechanics of the model aside which seemed to have worked well, I totally blew one very important prediction - the end VIX value itself. My prediction was that VIX would end in the range of 12-12.5, however, it ended at 14.37, far above my target. Humble pie is in order.

That said, I am not totally giving up on my VIX prediction model (as opposed the volatility ETP prediction model given VIX, as discussed above). This is how VIX has behaved this expiration week.

^VIX Chart

^VIX data by YCharts

I was sitting pretty Monday and Tuesday of this week, and even on Wednesday when VIX was hovering in or just above my predicted range. But Thursday, Initial Jobless Claims came far below expectations, markets crashed, VIX spiked, and with that my VIX prediction went out of the window, even though it performed rather well over most of my prediction time period. I first made my prediction of 12-12.5 VIX by August expiration in an article titled A Great Way To Play The Q2 Earnings Season published on July 10. VIX was above 14 then, and it did steadily fall since my prediction, going below 12 at some points and settling in at 12.3 3 days before expiration, only to spike. But if jobless claims came above expectations, my prediction would likely have proven to be spot on.

^VIX Chart

^VIX data by YCharts

What does this tell me? Well, it tells me that in the very short term - 2-3 days to expiration and forecasting end - everything goes, and especially everything goes if it is expiration week. I have a core principle never to hold options on expiration week as they become unpredictable. That principle was, once again, proven to be true. I had been urging my readers to get out of the VIX ETP options in the last two weeks, and got out of all my August positions last Friday. I will stick to this principle going forward.

So, this means overall the VIX prediction model, and the resultant volatility ETP prediction model worked quite well. Those that followed it and traded options should have made in excess of 100% returns over a month. I had made another prediction that SVXY/XIV would gain about 10-30% by August end in an article titled An ETF And An ETN That May Return 10-30% By August End. These have gained about 15% so far, and briefly were up by 20%. There is still time for these to gain (but with some risk that I will go into in a second).

Enough calibration. It is important to calibrate, as I trade based on my models, and if they are wrong then I need to fix them immediately. From what I see above, the ETP prediction model is conservative which is fine by me, and the VIX prediction model works well over the medium range - 5 to 6 weeks - but not in the very short period i.e., less than a week, which is something that can be traded around.

With that, I have run the models again for September. I am going to write a series of 3 articles (this one is the first one). First, I will show what the models are predicting for September at various VIX levels, using the same methodology hat I had described in my earlier articles. In a followup article I will share my VIX prediction for September, to feed into the volatility ETP models. In the last article, I will present my trading strategy based on the first two articles.

So this is what my models are telling me about the ending values at expiration for the various volatility ETPs, at various ending values of VIX.

$ 12.0 $ 11.9 $ 23.2 $ 133.2 $ 33.9
$ 12.5 $ 12.4 $ 25.2 $ 128.0 $ 32.5
$ 13.0 $ 12.9 $ 27.3 $ 123.1 $ 31.3
$ 13.5 $ 13.4 $ 29.4 $ 118.6 $ 30.2
$ 14.0 $ 13.9 $ 31.7 $ 114.4 $ 29.1
$ 14.5 $ 14.4 $ 34.0 $ 110.5 $ 28.1
$ 15.0 $ 14.9 $ 36.4 $ 106.8 $ 27.2
$ 15.5 $ 15.4 $ 38.8 $ 103.4 $ 26.3
$ 16.0 $ 15.9 $ 41.4 $ 100.1 $ 25.5
$ 16.5 $ 16.4 $ 44.0 $ 97.1 $ 24.7
$ 17.0 $ 16.9 $ 46.7 $ 94.2 $ 23.9
$ 17.5 $ 17.4 $ 49.4 $ 91.5 $ 23.3
$ 18.0 $ 17.9 $ 52.3 $ 88.9 $ 22.6
$ 18.5 $ 18.4 $ 55.2 $ 86.4 $ 22.0
$ 19.0 $ 18.9 $ 58.2 $ 84.1 $ 21.4
$ 19.5 $ 19.4 $ 61.2 $ 81.9 $ 20.8
$ 20.0 $ 19.9 $ 64.4 $ 79.8 $ 20.3

As shown above, these are likely conservative. The actual values will likely be lower for VXX and UVXY and higher for XIV and SVXY. I decided to show a larger range of VIX than before as I think there is a sizable chance of a VIX spike (and a fall as well given what we hear about tapering in the next few weeks). So, this is a wide range. That said, note that a VIX of 16 or above is needed for VXX/UVXY to increase and SVXY/XIV to decrease (adjusted for the conservativeness of the model). There is a real chance of VIX spiking above 16, but I would put the odds of that at no more than 50%. More on that later. In the meantime, I am straddling like a cowboy on VXX puts and calls.

Disclosure: I am long SVXY, XIV. 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 and calls in VXX and UVXY