VelocityShares Daily Inverse VIX Short-Term ETN (XIV) is a product issued by Credit Suisse AG. About ten million shares are traded per day and the market capitalization is above $800 million. XIV gained a huge success because its characteristics make it very profitable in certain market conditions. Not all XIV shareholders may be aware of these conditions. This article aims at avoiding them disastrous losses and harmful strategies. It also shows how to reduce the risk and boost the return in a very simple way.
XIV is a risky product by design. It is very volatile, termination events are defined since inception, and as an ETN it incurs an additional counterpart risk. Moreover, it is one of the most "derived" of derivatives. It is an ETP, which is inverse, derived from futures, derived from the VIX index, which is an abstract aggregate calculation on options, derived from stocks of the S&P 500 index. It means that the links with the usual market laws are indirect. As a consequence, usual analysis techniques might not work exactly the same way. Moreover, historical data on VIX derivatives are available on quite a short period. VIX futures started in 2004, VIX ETNs in 2009, and XIV on 11/29/2010. Since October 2011, there is an ETF equivalent to XIV: SVXY. It removes a counterpart risk and adds the possibility to trade options.
Credit Suisse calls termination "acceleration." The next quotes are extracted from the prospectus (downloadable here).
As discussed in more detail under "Specific Terms of the ETNs-Acceleration at Our Option or Upon an Acceleration Event"
in this pricing supplement, an Acceleration Event includes any event that adversely affects our ability to hedge or our rights in connection with the ETNs, including, but not limited to, if the Intraday Indicative Value is equal to or less than 20% of the prior day's Closing Indicative Value.
It means that the fund will be closed if its intraday loss goes beyond 80%, but Credit Suisse reserves the right to close the fund on other types of events, or on its own decision:
We will have the right to accelerate the ETNs of any series in whole but not in part on any Business Day occurring on or after the Inception Date.
If it happens...
...you will receive a cash payment in an amount (the "Accelerated Redemption Amount") equal to the Closing Indicative Value on the Accelerated Valuation Date.
XIV is not based directly on the VIX index, but on the S&P 500 VIX Short-Term Futures Index.
The S&P Dow Jones Indices website defines it as follows:
The S&P 500® VIX Short-Term Futures Index utilizes prices of the next two near-term VIX® futures contracts to replicate a position that rolls the nearest month VIX futures to the next month on a daily basis in equal fractional amounts. This results in a constant one-month rolling long position in first and second month VIX futures contracts.
In other words, XIV is holding and rolling short positions in the 1st month and 2nd month contracts so as to maintain everyday an average term of one month.
XIV has a very special bias for traders and investors: the term structure of underlying futures is most of the time in contango. The concept is easy to understand for commodities. Contango appears when buyers are ready to pay a premium for a later delivery. Just like a factory director anticipating higher raw material prices would try to buy stuff now, and rent a warehouse to store it. Contango can be assimilated to the warehousing cost. The opposite situation, called backwardation, can be interpreted as a premium for fast delivery. Volatility is a measure of risk. It is difficult to imagine risk being bought, stored and delivered. But it is what happens when options and VIX derivatives are used to hedge equity positions.
"Risk, I had learned, was a commodity in itself. Risk could be canned and sold like tomatoes."
Contango explains why XIV goes up when the VIX futures stay in a range, by short-selling contracts on the "expensive" 2nd month and covering former short positions on the "cheap" 1st month. The primary source of information for future contracts prices and contango calculation is the CBOE website.
When contango is negative (backwardation), the bias turns down. However, XIV may also go up when futures are in backwardation, if the price action of VIX future contracts is stronger than the bias.
Things turn bad when volatility is surging, which generally also brings backwardation. Then, both the bias and the price action are against XIV.
The average contango between the first and second months is 5% since future contracts inception (2004). Here is the contango chart between 4/26/2004 and 01/14/2014.
The two plunges below -20% are the 2008 crash and the 2011 stock market correction.
Here is the VIX index on the same period:
The next chart shows the hypothetical equity curve of $1 invested in XIV on 4/26/2004. It uses the real market price since inception date, and a synthetic price calculated from the underlying index methodology between 4/26/2004 and 11/29/2010.
This is the chart that investors need to look at. Some of them consider last two years as the normal behavior. It is not. Sure, globally XIV was multiplied by almost eight whereas the VIX index is back in the same range. But, who wants to hold an asset whose maximum drawdown was 95% and that was worth half its theoretical initial value after five years?
Now, here is the equity curve of holding XIV only when the underlying futures are in contango:
This chart does not take trading costs into account. The total return skips from 690% to 2860%. The maximum drawdown is still about 80%. But an 80% loss needs "only" a 400% gain to recover. In the former case, a 95% loss needs a 1900% gain.
Finally, this is the result of holding XIV only in backwardation:
It represents a 76% loss on the initial capital, or a possible gain with a long position in VXX, whose daily return is close to the opposite of XIV (I don't recommend to short XIV). Keep in mind that trading costs are not included here.
"Buy-and-hold" and "averaging down" are not suitable strategies with XIV. Buying the dips is not reasonable when successive dips may go down to -95%. Holding XIV only when VIX short-term futures are in contango drastically cuts the risk and boosts the return. However, even in this case the possible drawdown is still unacceptable for most of us. The final word is that XIV is an instrument that investors should consider only if they have either proven discretionary trading skills, or a systematic model. For readers wanting more details, a previous post describes the design of such a model (click here to read).