Over the last month, shares of the VelocityShares Daily 2x VIX Short-Term ETN (TVIX) have fallen by over 23% in a decline which accelerated in a 16% drop in the last 5 days. For long-term followers of the ETN, declines are largely to be expected due to the nature of its specific methodology; however, the magnitude of these declines has been fairly large in relation to history. It is my belief that going forward we will see further downside to the ETN but at a slower pace than what we are currently seeing.
Let’s start with a discussion of what TVIX actually is. Even though TVIX is a relatively simple concept (a double leveraged instrument tracking volatility), the implementation of the strategy is surprisingly complex with many layers of nuance. Let’s step through these layers and dig into the ramifications of the strategy.
First off, TVIX follows a twice leveraged return of the S&P 500 VIX Short-Term Futures Index. This index, created by S&P Global, gives a constant exposure to the front two months of VIX futures contracts through a continuous rolling process. VIX futures are created by the CBOE and settle based on what the VIX actually is reported at in a certain window. The VIX itself is an index which is the calculated implied volatility on a basket of options on the S&P 500 with a maturity of around 30 days into the future.
There’s a lot of layers there, but what it largely boils down to is that if you are holding TVIX, you are basically tracking a two-times leveraged constantly-rolling position in VIX futures. If you’ve ever followed an ETF or ETN which gives exposure to futures markets, you likely are immediately aware of the big red flag here: roll yield.
Put simply, roll yield is the gain or loss that investors receive through time from holding exposure across a forward curve in a month other than the front month contract. There is a basic tendency at work within futures markets in that as time progresses, contracts in the back of the curve tend to trade towards the front of the curve. This tendency means that if you are holding positions across the curve, the return you earn will vary based on the actual structure of the market.
When a market is in contango (front of the curve under the back of the curve), the roll yield on a long position will be negative because the long position held at higher prices will decrease in value relative to the front of the curve as time progresses. When a market is in backwardation (front of the curve over the back of the curve), roll yield will be positive on a long position because the contracts held in the back of the curve will tend to increase in value as time approaches expiry.
When it comes to trading volatility, there is one key concept which investors should always keep in mind: mean reversion. Put simply, volatility is highly mean reverting. When it increases, it is likely to decrease in the future, and when it falls, it is likely to rise in the future. This makes it fairly intuitive since if you’ve ever studied financial data, in the long run, the S&P 500 generally experiences a 10-20% annualized level of volatility. When times are scary and the volatility creeps up to 30-40%, you can pretty reliably say that volatility is likely to be less in the future. Conversely, when annualized volatility is under 10% or so, you can pretty reliably say that volatility will rise in the future. This simple relationship can be seen in the following chart which shows the correlation between past changes in volatility and future changes in volatility in the S&P 500.
What this means in terms of roll yield is that since volatility really doesn’t go anywhere in the long run, this means that the return of TVIX will be highly dependent on the market structure of VIX futures. And unfortunately for long volatility traders, VIX futures are almost always caught in contango. You can quantify this many ways (this website is good for further research here), but the long and short of it is that it rarely pays to play a strategy that continuously rolls long exposure in the VIX futures market. Here is the current market structure of VIX futures with the latest quotes from CBOE’s website.
At present, the market is heavily in contango. This means that roll yield for TVIX is negative and shares will in all likelihood continue drifting downwards simply due to the mechanics of roll yield. This in and of itself is a great reason to maintain a short position in TVIX shares (if you can find any to borrow). However, there are few specific setups in the S&P 500 which suggest that volatility will drop further in the immediate future.
There is a very interesting tendency in volatility of the S&P 500 which ties to direction movements in the index: it is asymmetrical. What I mean is this – when the S&P 500 is trending upwards, volatility tends to fall. Conversely, when the S&P 500 is trending downwards, volatility tends to rise. This tendency suggests that the market adage of “the market climbs stairs to the upside but takes an escalator to the downside” largely seems to be correct in that volatility expansion seems to generally occur when the S&P 500 falls.
There are a lot of ways of quantifying this relationship, but a simple price breakout of highs and lows does a good job of giving us the directional signal to examine the S&P 500. Specifically, here is the percentage of times that volatility was higher or lower in the S&P 500 following a touch of a 1-month low or a 1-month high in the index a certain number of days into the future.
As you can see, there is a fairly strong and reliable relationship: when the market makes new 1-month highs, volatility tends to fall more often than rise. With the price movements in the S&P 500 over the last week bringing us to fresh 1-month highs, we are currently in a period in which statistics would suggest that volatility will fall going into the future. Specifically, if the past is to be a rough guide to the future, then there is likely a 60-70% chance that volatility will be lower over the next 2 to 4 weeks than it is now.
This strongly suggests that holding TVIX (which gives long exposure to volatility futures) is a bad trade at this time and that best strategy is likely to short. When this is combined with the fact that roll is currently negative for the ETN, it’s basically a foregone conclusion: it’s time to sell or short TVIX.
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.