Easy Gains From XIV

| About: VelocityShares Daily (XIV)

A couple of comments on a previous article I wrote asked if shorting TVIX would be an effective way to profit from its inherent decay. The answer is no: the volatility and decay associated with VIX ETPs are already priced into options contracts and borrowing costs. What traders can do is go long on XIV, an ETN which tracks the inverse return of VIX futures.

Its important to note that the performance of VIX ETPs like TVIX, VXX and XIV depends on the performance of VIX futures contracts, not that of the spot VIX. This is significant because futures contracts alternate between contango and backwardation. During contango, contracts trade at a premium to the expected spot price of the underlying asset at maturity. As the contract nears maturity, the price of the contract and the spot price converge and the premium is shed. The shedding of this premium causes ETPs like TVIX and VXX to decay, but causes inverse VIX products like XIV to outperform. Below is a graph depicting contango in the April VIX futures contract.

(click images to enlarge)

Now compare this to the yields of XIV and VXX over the same period.

As you can see, despite the fact that the spot VIX rose almost 30%, XIV returned more than 10%, whereas VXX returned about -20%. This is because the VIX futures market was in contango at the time. Conversely, during backwardation, VIX products outperform and inverse VIX products underperform. We saw this happen last fall when the VIX hit the upper 40s.

What is significant about the VIX futures market is that short term contracts spend far more time in contango than they do in backwardation. In fact, the ratio of time spent in contango to time spent in backwardation is about 7 to 3. This means that in the long run, XIV will likely outperform the inverse return of the VIX and TVIX, and VXX will underperform.

That is not to say, however, one should just buy and hold XIV for years to come and not worry about it. Though backwardation is relatively infrequent, it can be severe and difficult to recover from. Just look at last July and August, where backwardation was so severe, XIV lost about three quarters of its value in less than two months. While backwardation of this magnitude is not exactly common, it is important to keep an eye out for it. Avoid holding it through backwardation, and XIV can become a very lucrative investment.

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