Cantilever Of The VIX Curve And February 5th
The CBOE Volatility Index (the "VIX") seeks to measure the market's current expectation of 30-day volatility of the S&P 500® Index, as reflected by the prices of near-term S&P 500® options. Because S&P 500® options derive value from the possibility that the S&P 500® may experience movement before such options expire, the prices of near-term S&P 500® options are used to calculate the market's view on the potential rate and magnitude of movements, or "implied volatility," of the S&P 500®. However, the options used to calculate the VIX are constantly in flux. As a result, unlike many indices, the VIX is not an investable index and therefore VIX derivatives, such as VIX futures, are used to gain exposure to price movements of the VIX. VIX futures contracts with shorter maturities have tended to have a higher beta to changes in the level of the VIX while contracts with longer maturities have tended to have a lower beta to changes in the VIX. The reason is relatively intuitive: market uncertainty (or calm) today may imply market uncertainty (or calm) tomorrow, but not necessarily in six months or a year.
This dynamic is analogized by a "cantilever model." As the architects among us will recall, a cantilever is a beam with one end fixed and the other end freely moving. In this analogy, the fixed end behaves like the long maturity contracts. The free one like the short. Although the analogy is not perfect, it is helpful in understanding curve dynamics.
The Long Term View
In order to quantify the typical relationship between VIX futures contracts and VIX, the CBOE has analyzed data from March 26, 2004 through May 26, 2017, based on time to expiration. The CBOE encountered a relatively consistent pattern, illustrated in the following graph:
Historical data thus suggests that VIX futures contracts that are near expiration tend to be more sensitive to underlying movements in the VIX. This historical data on sensitivity to movements in the VIX, or "beta," is roughly approximated by CBOE using the following equation:
In other words, the historical data suggests that contracts with 10 days to maturity tended to move about 60% as much as movements in the VIX itself. Likewise, movements in the VIX tended to correspond to an approximately 50% move for contracts with 20 days to maturity, and to a 40% move with contracts with 40 days to maturity.
February 5th 2018
Though they may serve as a guide, these historical relationships cannot necessarily predict how VIX futures contracts will correspond to movements in the VIX going forward. On February 5th, in conjunction with a market-wide selloff, the VIX index jumped 116%. As shown below, the futures curve responded in "cantilever" fashion, with the 1st contract moving 113%, the 2nd contract 87%, the 3rd contract 64%, the 4th 37%, etc.
Source: Bloomberg
The move was generally consistent with historical behavior in that futures contracts with shorter durations moved much more than their longer dated peers. Its size, of course, was exaggerated by the size of the spot VIX move, which was the biggest one day jump (on a percentage basis) on record.
Extreme Move
As February 5th, 2018 showed, spot VIX can jump more than 100% in one day. Not only that, the 1st futures contract can also move more than 100% a day. Indeed, the move for many of the futures contracts was even higher than the CBOE's calculation for beta would suggest. The table below shows the actual moves on February 5th compared to what might be expected based on historical betas:
On February 5, an investor with a short notional position in 2nd month futures contract would have been down -86.8%. However, given the historical relationship between movements in the VIX and movements in the futures contracts, this investor might have expected to only be down about -46.4% in the event of a 115.6% movement in the VIX. In fact, we see that larger than predicted moves occurred in a number of contracts with shorter expirations, but that contracts with longer durations tended to experience movements more in line with what historical betas would suggest. This suggests an approach that factors in a buffer for moves in excess of what may be "predicted" could be warranted for investors wishing to limit potential losses from short VIX futures positions.
On February 23, 2018, REX Shares announced that our two volatility funds, VMIN and VMAX had filed updates to the prospectus that revise their stated Principal Investment Strategies. Going forward, the Funds expect to invest primarily in VIX Futures Contracts with two to six months to expiration, rather than VIX Futures Contracts with less than one month to expiration as was previously the case. This transition will be completed by March 21, 2018 and after that date, more detail will be available at www.volmaxx.com.
Disclaimer
Carefully consider the Funds' investment objectives, risk factors, charges and expenses before investing. This and additional information can be found in the Funds' prospectus. Read the prospectus carefully before investing.
The Funds should be utilized only by investors who (a) understand the risks associated with seeking short term investment exposure, (b) are willing to assume a high degree of risk, (c) understand the risks of shorting and (d) intend to actively monitor and manage their investments in the Funds.
Investing involves risk, including the possible loss of principal. These Funds are actively managed and there are no guarantees investments selected and strategies employed will achieve the intended results. Active management may also increase transaction costs. The Funds expect to invest primarily in VIX futures contracts, which are considered commodities. VMAX and VMIN are not benchmarked to the VIX Index, which is calculated based on the prices of put and call options on the S&P 500® Index. As such, both Funds can be expected to perform very differently from the VIX Index. Although VMIN seeks to provide "short" exposure, the Fund does not promise or seek to provide any specific negative multiple of the performance of the VIX Index or VIX Futures Contracts over any specified period of time.
The use of derivatives, such as futures contracts, swap agreements and options, presents risks different from, and possibly greater than, the risks associated with investing directly in traditional securities. Changes in the value of a derivative may not correlate perfectly with the underlying security, asset, rate or index. Gains or losses in a derivative may be magnified and may be much greater than the derivative's original cost. The derivatives may not always be liquid. This could have a negative effect on the Funds' ability to achieve its investment objective and may result in losses.
The Funds will invest in exchange-traded notes and exchange-traded funds, and will be subject to the risks associated with such vehicles. The Funds' performance will be directly related to the performance of those investments.
The return for investors that invest in VMIN for periods other than a full trading day will differ from VMIN's stated daily inverse investment objective. During periods of high volatility, VMIN may not perform as expected and may have losses when an investor may have expected gains if VMIN is held for a period that is different than one trading day. Shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. VolMAXX NAVs are calculated using prices as of 4:15 PM Eastern Time. The closing price is the Mid-Point between the Bid and Ask price as of the close of exchange.
The Funds are non-diversified. Indexes are unmanaged and one cannot invest directly in an index.
Exchange Traded Concepts, LLC serves as the investment advisor and Vident Financial serves as sub advisor to the fund. The Funds are distributed by SEI Investments Distribution Co. (One Freedom Valley Dr., Oaks, PA 19456), which is not affiliated with Exchange Traded Concepts, LLC or any of its affiliates.
The CBOE Volatility Index (the "VIX") is a product of S&P Dow Jones Indices LLC ("SPDJI") and is based on the CBOE VIX methodology, which is the property of Chicago Board Options Exchange ("CBOE"), and has been licensed for use by REX Shares, LLC ("Licensee"). S&P® is a registered trademark of Standard & Poor's Financial Services LLC ("S&P"); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC ("Dow Jones"); CBOE® and VIX® are registered trademarks of the CBOE. The CBOE VIX methodology and the trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Licensee. Any investment product or strategy based on the VIX is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, or CBOE and none of such parties make any representation regarding the advisability of investing in such products nor do they have any liability for any errors, omissions, or interruptions of the Index.
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