I recently wrote an article noting what many others have noticed and mentioned recently, which is that volatility is currently sitting at abnormally low levels. I analyzed historical closing prices of the Volatility Index (VIX) and found a seasonal pattern such that volatility is lower during summer months than non-summer months. Based on this data, I proposed an investment thesis to go long on volatility at current levels and hold till the August-October timeframe. But, how do you go long on volatility? The feedback I received from the article was insightful in reshaping some of my ideas about volatility and in gathering more data to answer questions that I had not considered. I am very grateful to the people who took the time to comment and suggested excellent alternate investment strategies. I am also grateful that such a forum exists for productive discussions on investment ideas and specific strategies. I would like to take another crack at outlining my investment thesis and present alternative strategies for engaging in this thesis.
The VIX is currently at abnormally low levels. When I wrote the original article, VIX was at 11.0. More recently, it has spiked a little due to tension in Iraq and currently stands at 12.56. This is still unusually lower than its typical baseline. I say this based on observations that the historical median closing level of VIX is 18.9. The VIX's range 50% of time is between 14.6 and 23.7, the range 75% of time is between 12.0 and 29.1, and the range 95% of the time is between 11.3 and 37.2.
Source: Historical price data from Yahoo Finance.
In the article, I proposed that the current low volatility may be in part due to seasonality. I analyzed the daily historical closing prices of the VIX for the last 25 years and found that VIX levels were significantly lower in summer (April to July) than the rest of the year. During summer months, trading volumes are typically lower than during non-summer months since market participants are on vacation. From a behavioral perspective, less trading volume implies fewer speculators that in turn will lead to less volatility.
Source: Historical price data from Yahoo Finance.
Based on this data, the investment thesis I suggested was to go long on volatility and hold till the August-October timeframe.
In order to understand the various investment strategies possible for volatility, it is first important to fully understand the VIX. The VIX measures volatility and since its introduction in 1993, it has proven valuable as a market indicator of future volatility. It works by taking into account the prices of many out-of-the-money calls and puts for the front and second month expirations. A VIX level of 12 represents an expected annualized change of 12% in the S&P 500 over the next 30 days translating to a 12%/(12^0.5) = 3.46% change in the S&P 500 over the next 30 days. More detailed information is available here.
It is not possible to buy or sell shares in the VIX as you can with equities or other indexes. The only way to directly invest in the VIX is via recently introduced options in the VIX. However, there are many other investment vehicles for investing in volatility. Each of these vehicles is an imperfect solution, but allows for some interesting possibilities.
It is important to note that VIX options are priced according to the VIX futures (VX) and not the spot price of the VIX. To get a sense of the discrepancies, the current spot price of VIX, which is displayed under ticker INDEXCBOE: VIX at Google Finance is 12.56 and the current futures price for June 20th expiration, which is available here, is 13.18.
I found historical closing prices for VIX 1 month back futures from 2007 to 2014 and plotted them alongside the VIX spot prices below.
The price of VIX futures is based on the expected spot price of VIX on the expiration date. Typically, the further away the expiration date, the higher the futures price will be; for instance, the futures price for the September 19th expiration is 15.71. The spot price and futures price will converge on expiration date but for the vast majority of time (~80%), the futures price will be higher than the spot price. This phenomenon is known as 'contango' and to put it simply, the higher price for the futures reflects a flexible premium paid now for the right to buy something in the future. When the futures price is lower than the spot price, this phenomenon is called backwardation and it rarely happens.
VXX and VXX Options
The iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) is the most popular exchange traded note (ETN) to invest in volatility and was introduced in 2009. The performance of the VXX since inception is shown below in brown, in relation to VIX shown in blue. The VXX has declined a surprising 96% since inception.
The VXX operates by using complex VIX futures trading strategies. One of the drawbacks of this and other ETNs is that they are subject to management fees. The biggest drawback, however, it that the ETN is required each day to sell some front month options and buy some second month options. The problem with this is that as discussed above, second month options are more expensive than front options during contango that occurs ~80% of the time, resulting in a buy high, and sell low strategy. What this means is that a buy-and-hold strategy is out of the question for the VXX because the longer you hold VXX, the more likely you will be affected by contango.
Using the VXX to invest in short-term moves in the VIX is possible, but not one I recommend since spikes in volatility are difficult if not impossible to time. Investing in VXX options is also a viable strategy that many investors prefer to VIX options since in this case, there is no discrepancy between the spot and futures prices. However, the day-to-day correlation is on average about 50% i.e., the VXX will move about 50% of the move in the VIX in the same direction as the VIX. Given the underlying problems with the VXX as stated above, I do not recommend VXX options as way to go long on volatility.
Other ETNs and Exchange Traded Products (ETPs)
There are several other investment products now available to invest in volatility including:
- iPath Inverse S&P 500 VIX Short-Term Futures ETN (NYSEARCA:IVOP)
- ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY)
- VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX)
- ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY)
- VelocityShares VIX Short-Term ETN (NASDAQ:VIIX)
- ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY)
- VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV)
- iPath Inverse S&P 500 VIX Short-Term Futures ETN (NYSEARCA:XXV)
In general, these are all risky to trade and best used in a situation-specific manner when expecting spikes in volatility, rather than for establishing a long-term position in volatility that is based on expecting seasonality. What is exciting is that a third generation of volatility products are currently being designed to more closely match the VIX with fewer imperfections that plague the current second generation products listed above.
I outlined various different possibilities above that allows investors to take a position in volatility. Of these, there are few good options to take a long position in volatility that takes advantage of the inherent seasonality in volatility as well as current abnormally low levels of volatility. The most promising strategy to me involves VIX options expiring in the August-October timeframe. A bullish position in the VIX can be taken by either buying calls or by selling puts. Before looking at options, I wanted to analyze whether the same seasonality also manifests in VIX futures prices in addition to VIX spot prices.
Source: CBOE historical prices for VIX futures.
The above dataset was obtained from 2007 to 2014 and because of the small size of it, there is not enough statistical power to compare data from summer months to that from the rest of the months. However, the futures prices largely mirror the spot prices and on any given month, there is no significant difference between the futures and spot prices. Moreover, there is a similar trend in seasonality in futures prices whereby there is more volatility is VIX futures in October and November, relative to April through to July.
The seasonal data in VIX spot prices averaged by month from 1990 to 2014 shows a difference between the June and September months of 2.94 points and between the June and October months of 4.17 points. This amounts to a VIX level of 15.12 in September from current levels and to a VIX level of 16.35 in October from current levels. The below table lists the different call and put options for September and October. In addition, I have listed breakeven prices at expiry, maximum risk, maximum reward, and for selling puts, the annualized rate of return. The most attractive strike prices are 15 for September 16 for October.
Again, these options are all based on futures prices listed below and not on the spot price of the VIX. The October futures price, for instance, is currently at 16.15, which already reflects increased seasonality in volatility discussed above.
A bullish position in the VIX can be taken by either buying calls or by selling puts. The call prices listed below have a high breakeven price indicating that buying calls is well suited when expected a spike in volatility levels (infinite upside), but not as well suited if only expecting a relatively small increase in baseline levels. However, strike 15 puts expiring in October and strike 16 puts expiring in November offer excellent annualized rates of return.
The feedback I received from my previous article on volatility was very insightful in reshaping my views on volatility and brought me to consider aspects of volatility that I had not previously considered. I have a great deal more respect for volatility now and still stand by my investment thesis that this is an excellent time to go long in volatility based on seasonal patterns and the fact that volatility is currently at abnormally low levels. An important caveat is that of course, past trends do not predict the future and it is conceivable that the VIX will remain at these levels well past the summer months. While there are many investment vehicles for investing in volatility, I recommend VIX options as one vulnerable to the fewest biases and imperfections. In particular, selling puts expiring in September or October should provide the best risk/return ratios.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.