Over the last month, VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV) have risen by about 6% after seeing a brief drop in price due to a surge in volatility in VIX futures.
In this article, I will make the case that buying the pullback in ZIV makes for a sound trade both on the basis of the rolling methodology of the ETN as well as the current underlying volatility regime in which the market is trading.
Let’s start with a discussion as per the methodology of what exactly ZIV is and why it is critical for investors to understand the underlying mechanics at work in the instrument. First off, the VelocityShares Daily Inverse VIX Medium-Term ETN is an instrument which gives exposure to the inverse of the S&P 500 VIX Mid-Term Futures Index which is an index that constantly rolls a position in the 4th through 7th VIX futures contract.
There’s a lot here, so let’s unpack it. First off, the VIX is an index which is calculated off of S&P 500 index options with a target maturity of 30 days into the future. The VIX itself can’t be traded since it is just an implied volatility calculation based on the prices of specific options on the S&P 500 index, but the CBOE created VIX futures which are cash settled based on the VIX at a certain point in the future. S&P has constructed a few different indices which track VIX futures and each of which has a specific target window of which contracts to hold. In the case of ZIV, it is utilizing the mid-term index which is basically a position spread out across four separate months which it incrementally rolled every single day to maintain constant exposure.
The reason why investors would chose a mid-term index versus the short-term front-month rolling index in VIX futures is roll yield. Roll yield is the gain or loss that occurs as time progresses due to the fact that futures contracts tend to trend towards the front-month contract as time progresses. The following chart from Wikipedia shows the forces at work in a normal market which cause roll yield to occur.
As you can see, when a market is in contango (back month contracts are above front-month contracts), if you are rolling a long position, you will be losing money on the roll since the long contracts established at higher prices will trade down in value in relation to the front-month contract as time progresses. Conversely, if the market is in backwardation (front month contract above back month contracts), roll yield on a long position will be positive because the long position at the lower-priced back-month contracts will trade up in value towards the spot price as time progresses. There certainly are periods of exception from this rule, but it is a strong enough market tendency that some investment strategies specifically target roll yield as the primary source of return.
In the case of VIX futures, roll yield plays a massive role in determining the ultimate returns of the indices which track the market because VIX is a trendless index. What I mean is that if you look at volatility over long periods of time, it is fairly consistent and largely sits around a long-term average level. Brief excursions in either direction tend to be followed by a reversion to the mean. This means that a strategy which is rolling exposure across the VIX futures curve will see most of its returns come directly from the roll.
In the case of ZIV, it is an inverse ETN which tracks the 4th through 7th month contracts. The basic idea behind this instrument is that by trading the 4th through 7th months, roll yield will possibly be much less than an instrument which has a heavily-weighted position riding in the front of the curve. The front of the curve tends to be much more volatile than the back of the curve which means that dramatic differences between months tend to clump in the first few months while the back generally is rather tame. For example, here is the current VIX futures curve.
It’s hard to see in the chart, but the front two contracts are trading in backwardation by 0.3 percent (VIX represents an annualized volatility number) and the back four contracts are currently averaging a month-to-month differential of 0.17 percent.
ZIV is currently rolling a short position in January through April which is currently at an average backwardation of 0.17 percent. This means that roll yield is negative for the instrument since it is shorting in a backward market (back-month futures will rise to approach the prompt). This will be a negative drag on the instrument, but the market is largely in contango for most months since the market anticipates higher volatility in the future than the present if markets are calm – which they generally are.
Since ZIV has relatively long-term exposure grouped at the back of the curve (which limits the impact of roll), we can place a little more emphasis on outright levels of volatility and its mean reverting nature.
Specifically, volatility in and of itself is highly mean reverting. VIX itself isn’t actually a measure of realized volatility (it is implied volatility on a basket of index options with a 30 day maturity), but its properties mimic realized volatility fairly consistently. For example, a simple glance at the VIX shows the basic underlying truth: quick pops are followed by rapid drops.
At present, we have seen a strong rally in VIX due to the S&P 500 falling fairly sharply over the last week. The reason why VIX rose is that as the S&P 500 falls, the implied volatility of S&P 500 put options skyrocketed resulting in the index increasing by about double (12% to 24%) in the space of 5-6 days. Volatility is highly mean reverting and we are currently seeing implied volatility trade back down towards the average which means that ZIV (which shorts VIX futures on an outright basis) will see gains.
The reason why now is a perfect time to buy ZIV is that the downwards cycle in the S&P 500 appears to be over in the short term which means that implied volatility on S&P 500 put options will decrease leading to a drop in the VIX and a drop in the VIX futures market. When VIX futures drop, it tends to push the market into contango which will turn roll yield positive for ZIV. To give a statistical tailwind to this recommendation, I’ve gone back and looked at what happens when the VIX rallies by 5.45 points or more in a given week (last week’s rally). There have only been 16 occasions where this has happened in the last 5 years and the VIX was lower in 81% of them over the next month. In other words, we are currently in a statistically-strong period in which we should be shorting the VIX and buying ZIV (I’d suggest through options to avoid serious tail-risk) to get direct exposure to this move. It’s a great day to buy ZIV.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.