In preparation for the Bernanke testimony in front of Congress on Wednesday 7/17/13, volatility spiked on Tuesday 7/16/13. I believe this has presented investors a great opportunity to gain 10-30% over the next month by investing in either of the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) or the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY).
Per Seeking Alpha, this is the description of the XIV ETN
The VelocityShares Daily Inverse VIX Short-Term ETNs (the "ETNs") are senior, unsecured obligations of Credit Suisse AG ("Credit Suisse") acting through its Nassau branch. The return on the ETNs is linked to the inverse of the daily performance of the S&P 500 VIX Short-Term Futures™ Index ER less the investor fee. The ETNs provide traders with an exchange traded instrument enabling them to efficiently express their market views on the short-term futures contracts on the CBOE SPX Volatility Index® (the "VIX®"). The ETNs do not guarantee any return of principal at maturity and do not pay any interest during their term.
Also per Seeking Alpha, this is the description of the SVXY ETF
This Short ProShares ETF seeks a return that is -1x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their holdings consistent with their strategies, as frequently as daily.
These two ETFs return on a daily basis the inverse of the return of the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). The VXX ETF in turn keeps exposure of one month in the two front month futures on the volatility index (VIX). It will invest in the combination of the two forward month futures such that its weighted average exposure is a month. This is how it works.
Today was the expiration of the July VIX futures, so as of end of day today the VXX ETF is fully invested in the August futures. Over the next 5 weeks it will sell a portion of its August futures every day and buy September futures on VIX, to maintain the one month average exposure. Since September futures are currently trading at around 7% higher than the August futures, each time it does this it will lose a little bit of money, known as the roll yield (loss). In addition, the August futures is currently about 12% higher than the spot VIX, so that will erode as well, as it must match spot VIX on expiration.
For readers interested in knowing how this works out in practice, I recommend this site.
Following this algorithm, I have created a model predicting VXX and XIV returns by August exipration. A snapshot of the model is shown below. The model should be self explanatory. n1 and n2 are the number of units of the two futures held per share of VXX on any given day, and V1 and V2 is derived by multiplying the number of units with the future price. The key input to the model is the ending value of VIX by August expiration. In the snapshot below this is set to the closing value of 14.5 as of 7/16/2013 i.e., VIX remains unchanged.
The model makes some simplifying assumptions. It assumes that VIX changes in a linear manner. For example, If VIX were to drop 25% over the next 5 weeks, the model assumes that each day VIX would lose about 1.1% such that in 25 days the final VIX value is 25% lower than the current one. It also assumes that at expiration the August futures match the spot VIX, and the September futures are about 12% higher than the August futures, as it has happened in July. (There is some rounding in the model above). It also assumes that the VIX futures follow a linear path.
In reality, there will be day to day fluctuations, but I have backtested this simple model and found that it is quite accurate as long as the ending VIX value and first to second month contango is accurate at expiration.
Finally, the model calculates daily XIV changes as inverse of daily VXX changes which holds well in reality. As the model shows above, if VIX remains unchanged by August expiration (regardless of the path it follows in between), VXX is likely to lose about 10%, and XIV to gain about 10%. SVXY gains should be identical to XIV gains in percentage terms as they follow the same algorithm.
What if by August VIX hits the May lows of 12.5? In that case, the model indicates that VXX drops by about 22%, and XIV gains by about 27%. And at a VIX of 12 by August expiration, VXX drops by 25%, and XIV gains by 32%. Hence, between a VIX of 12-12.5 XIV (and SVXY) should gain about 30%, and if VIX stays flat, it should gain about 10%.
What if VIX spikes in by August? According to the above model, VIX will have to be at 16 for XIV/SVXY to stay flat. If and only if VIX spikes above 16 will these two start to lose money. Given that, I think there is a good investment case to put money into one of these two - XIV and SVXY.
I believe VIX will be at or around 12-12.5 by August, and the chance of a spike about 16 is minimal. As to why, interested readers should check out my other article named A Great Way To Play The Q2 Earnings Season on that topic.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in XIV over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.