Making Money With Inverse Volatility

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 |  Includes: IVO, XIV, XXV, ZIV
by: David Oldenburg

I have written many articles on trading strategies for volatility. I recently wrote about trading the VXX and XIV and going long on both (previous article). However, in this article I am going to talk about the benefits of trading inverse volatility when it comes to contango, flat markets, bull markets and max loss in break-out volatility markets.

The players in the inverse volatility world are XXV, IVO, XIV and ZIV. All four of these trading vehicles have low volume and none of them are optionable, however, trading volume is slowly increasing now that traders are starting to see the advantages of trading inverse volatility.
XXV The Little Engine That Could
I really like both XIV and XXV. On the surface if you look at the inverse volatility XXV, it looks like a boring ETN trading vehicle that moves only a fraction of how much VXX moves. Yesterday the VXX ETN closed up 7.52% and the inverse XXV moved down just 1.23%. XXV does not appear to be a great hedge for VXX but it reminds me of the little engine that could. Take a look at the chart I have provided here (click to enlarge) of the S&P 500 and XXV over the last 6 months. The SPY is up a little over 20%, an incredible return over a 6-month period. However, the XXV is up almost 40% during the same time period.

XXV Versus S&P 500Click to enlarge
XIV A Monster In A Bull Market
XIV is also an inverse volatility ETN that benefits in the opposite direction of VXX. XIV began trading just over 3 months ago. On December 1st, it was trading around $97 per share and rocketed up 60% to $159 before dropping back to around $130 with recent volatility. The incredible beauty of XIV and XXV is that they benefit from the contango that causes VXX to be such an incredible under-performer.
If you look at VXX over the last 2 years, it was trading at around $460 two years ago and today is around $30. Much of the decline is due in part to decreasing volatility over the last 2 years. If you go back to March 4th, 2009, the VIX was at $48 and is now down about 60% to around $20. The VXX was around $431 two years ago on the same date and is now down around $32, a 93% decline. The reason for the difference between the VIX and the VXX is what is called contango, the slow decay from rolling futures contracts. Since the XIV benefits from contango in the same way that VXX is hurt, the XIV will gain in most flat markets and most rising markets. It will takes it's biggest loss as volatility rises, as we have seen recently with the XIV trading from $159 to $130 in a few days.
Max Loss On Your Side
There are a lot of traders who have shorted the VXX and most have done well, with the exception of a few volatility spikes. However, shorting VXX opens you up to an unlimited loss should volatility go crazy with another 9/11 or other unforeseen crisis. Being long an inverse volatility vehicle takes out all the risk of having an unlimited loss on your investment should volatility spike extremely high.
If you are smart and purchase XIV in a cash account (not margin), you can just hold your shares if they drop and even buy more to lower your cost basis. The good news is that while most volatility spikes are sudden and large, they are also usually very short in time. Even in the financial crisis of 2008, the VIX dropped 50% within 5 months of hitting a record high. Had the XIV been trading during the 2008 financial crisis, it would have seen a dramatic loss but anyone who purchased more shares at the lower price would have been greatly rewarded since that time. Again, shorting VXX opens you up to unlimited losses, yet going long XIV gives you the same advantage as shorting VXX with limited loss and the ability to buy more shares should the price drop.
VXX Hedge
I have spoken to a few traders who believe a 50% or 75% VXX long and a 100% XIV long is the best of both worlds, as it will yield profit in a flat or rising market and provide some downside protection should volatility spike for a period. XIV has only been trading for just over 3 months, so I have yet to form a solid opinion on the best hedging strategy with VXX.
Making Money With Volatility
With so many new volatility trading vehicles hitting the market and more to come, there will definitely be opportunities for sharp traders to figure out ways to use them to their advantage. If you have a volatility trading strategy or idea, be sure to mention it here in the comments or contact me directly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.