What are the implications for the market outlook of the analysis in the previous post for the "real world" of the markets:
It seems the market anticipates near term volatility no doubt on the downside in particular.
As for those watching the VIX, iPath's S&P 500 VIX Short-Term Futures ETN (VXX) and iPath's S&P 500 VIX Mid-Term Futures ETN (VXZ):
The period since the introduction of the VXX has no doubt been extremely painful and frustrating for those that held it. Since the VXX represents the near term future and the contango was very large, the VXX suffered large losses due to the cost of rolling futures contracts as they expired. Hence the sharp decline in the VXX far more extreme than the cash index. As for the VXZ, the losses were less extreme because of the less extreme curve between the mid date futures it represents and the less frequent roll trades.
But judging by much analysis I have seen, people have thrown in the towel on the VXX based on the short time period since the instrument has started trading. As seen in the table below (click to enlarge) as the VIX increases to extreme levels, the curve of term structure flips. In other words, the holder of the VIX gets an extra boost in return just when he wants the hedge to be most effective.
Effectively, the time decay of option premia hurt the VXX far more than the VXZ. And the VXX is more sensitive to changes in the VIX than is the VXZ.
This differential means that the VXX is far more sensitive to changes in the VIX than the VXZ. The "hedge ratio" ration of price change in the ETN relative to change in the far higher for VXX to VXZ.
As volatility and the VIX increased massively over recent trading days this was readily apparent. The long suffering VXX holder saw their positions increase a multiple of the VXZ and a large multiple of the actual volatility in the S&P 500 and by extension the global equity markets. Those looking for a 1:1 movement between the VIX and one of the ETNs were disappointed but they were looking for the wrong result. The ETNs are linked to the future not to the VIX which is an index and cannot be traded.
The correct way to look at these instruments is either as a hedge of a long equity position or a trade. Since volatility is more extremen on the downside, the VXX or VXZ position would offset those losses And the instruments performed extremely well. The VXX for instance on Friday moved the same percentage move in the S&P 500, as the VXZ moved. Furthermore, with the flip in the futures curve from contango to backwardazation the VXX will likely suffer little or no loss when rolling contracts.
So what is the bottom line for use of the VXX and VXZ?
They should be viewed as a way to offset the actual volatility of the S+P 500 either as a trade or a hedge.
Traders should look to the VXX which has a higher leverage to the underlying moves but in a slow market will be translated to a far steeper decline in value. The volatility is far higher for the VXX. But the leverage of the VXX is quite large - it recently moved 4-5x the move in the S&P 500.
Those looking for a longer term hedging vehicle should look to the VXZ. Recently it moved around 2x the move in the S&P 500.
Using the above numbers one could argue that a 20-25% position in VXX would offset all of the loss on a stock portfolio during turbulent times. For VXZ it would be closer to 50%.
This instrument has an added benefit. In a turbulent down market we have observed two things:
Volatility spikes increasing the leverage of these instruments. Among equities, diversification becomes weaker and "the only thing that goes up in a down market is correlation.. So these instruments provide a hedge (although of course of not identical efficacy ) of the non US parts of an equity portfolio as well as the small cap US despite the fact the S&P 500 is large cap US stocks.
Here are three-month graphs of the VXX (top) and VXZ (click to enlarge). Note how painful the futures roll has been for longer term holders of the VXX while recently the market has been more favorable to VXX over VXZ holders.
So what would be the optimal strategy for those that want to hold a black swan hedge in their portfolio? A longer term position in the VXZ, an addition of VXX positions, or a partial swap from VXZ to VXX in anticipation of higher volatility in the market and a reversal of the position during a time of market stability.
Of course the likelihood of getting that timing right is as great as the likelihood of timing any other market. But a mix of a larger position in VXZ combined with a smaller proportion of VXX is probably the best approach with the caveat to avoid the VXX completely when the futures market is in deep contango.
Disclosure: The author has a long position in VXX.