Playing Inverse Volatility for Easy Gains

Aug.11.11 | About: VelocityShares Daily (XIV)

Investing can be difficult, especially in markets like these. It's very difficult to tell which sectors will weather this storm the best. Or do you even want to try to weather this storm? Maybe the best place to be is on the sideline. But even then, how will you know when it's safe to dip your toe back in the market's waters?

The goal of every investor is to maximize return while minimizing risk. But risk and return tend to be competing factors. Stocks can be very fickle instruments. Even the best-analyzed "value" stock bought today can quickly become an even bigger value as it falls precipitously tomorrow. We've all been there at least a time or two. Wouldn't it be nice if you knew where a security was going before you invested in it? The obvious answer is yes, but how do you find such a security? While stocks tend to move up and down based on a variety of factors, the movement of volatility is predictable, to a degree. The CBOE Volatility Index has one characteristic, that if played at the right time, should eventually pay out a nice return, at minimal risk. That characteristic is mean reversion.

Since 1990, the VIX (NASDAQ:XIV) has ranged from a minimum of 9.31 to a maximum of 89.53 (intraday values). However, this range of data is not normally distributed. The average daily close on the VIX over this time period has been 20.35. When the VIX goes north, it tends to go quickly and set large, temporary spikes. But the VIX always eventually returns to a range near its average over time.

A simple strategy to take advantage of this mean reversion would be to short the VIX any time it exceeded a certain value, then ride it down until it returns to its average. For the purposes of studying this phenomenon, I took the closing value of the VIX on August 5, of this year, 32. Since 1991, (not counting the current VIX spike) there have been 12 instances of the VIX exceeding 32. 12 out of 12 times, the VIX has returned to a level below its long-term average of 20.35. In fact, the average "short-VIX return" for those 12 instances would be 73.87% over an average period of 114 trading days. If you invested $1000 in this strategy at the first instance of VIX exceeding 32, and then rolled the profits over for the remaining 11 instances, you'd have $747,618 today. In markets like this, that's a return that can't be ignored. (For comparison, buying and holding the S&P 500 (NYSEARCA:SPY) over the same time period would have turned $1000 into $3484).

So the next question would be, how to short the VIX. While in the past, you'd have to dabble in options or futures, a fairly young ETN has made it a lot simpler. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV) was designed to track the daily inverse performance of the VIX.

Since it has only been trading since November 30, 2010, there is not a lot of data yet to get an accurate reading on how well it actually tracks the inverse performance of the VIX. But some initial research shows that it has a lot of promise. I found that since its inception, on days that the CBOE Volatility Index went up, XIV went down, on average, at a rate of about 43% of the VIX up-move. On days that the CBOE Volatility Index went down, XIV went up, on average, at a rate of about 46% of the VIX-down move.

While that might not sound like much of a difference, over time, it has added up. Perhaps more telling is to compare the two from inception to present. Since November 30, 2010, the CBOE Volatility Index has risen 82.6% (from 23.54 to 42.99). This would suggest a massive decline in XIV. However, XIV has only fallen 3.2% over the same time period. Due to the nature of how the ETN is set up, XIV benefits from positive roll yield when the contracts that back the ETN expire. This tends to help XIV accumulate positive returns in not just a downward-VIX environment, but a sideways-VIX environment as well.

Based on the very limited data I've collected for XIV, if you bought XIV at the close August 5, when the CBOE Volatility Index was 32, capturing an average of 46% of the average 73.87% "short-VIX return," the investment should net approximately a 34% return in an average of 114 trading days (roughly mid-January 2012). Obviously, I put no guarantee on forward-looking performance projections. Always remember that past performance is no guarantee of future performance. This article was merely an attempt to use historical volatility movements to explore a potential way to profit in a turbulent market.

I would be remiss if I did not close this out with touching on counterparty risk. XIV is an ETN that is backed by a counterparty. The ETNs and payment of any amount due on the ETNs are subject to the credit risk of Credit Suisse. This type of investment is not suitable for all investors. Before investing in XIV, read the prospectus, and know what you plan to own.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in XIV over the next 72 hours.

Disclaimer: Trading involves risk. Nothing in this article is intended to constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold any securities. The author and certain individual clients of the author may be invested in securities discussed in this article. Consult your investment advisor before making investment decisions based on concepts presented here.