Over the past few weeks, shares of the ProShares Ultra VIX Short-Term Futures ETF (BATS:UVXY) have slipped on the back of a decrease in the level of the VIX as seen in the following chart.
As we’ll discuss in this article, I believe that UVXY is headed lower. Specifically, I believe that the forces of negative roll yield as well as the mean-reverting nature of the VIX are indicating further downside in UVXY over both the short- and long-term future.
Understanding Volatility
Prior to ever trading the VIX or any VIX-linked ETPs like UVXY, it makes a lot of sense to take a step back and actually understand the mathematics around VIX movements. The reason why it is critical to do this step is that through understanding, we can better be equipped to call future directions in volatility and position accordingly.
As I’ve said before when discussing UVXY, the key thing to keep in mind is that the VIX is mean reverting. That is, when it goes up over a certain time period, it tends to fall in the future. This chart is generally my departure point for understanding what is the most likely move for the outright VIX over the next month.
If you reference the first chart of this article, you can see that the VIX is currently sitting at around 32. This number isn’t shown on the chart above, but the relationship of declining odds of upside continues into the future. Put simply, given that the VIX is sitting at 32, the last 27 years of market data would say that there’s only about a 30% chance that the VIX will rally over the next month. In other words, a short trade in the VIX itself has about a 70% chance of making money over the next month.
When it comes to the average move seen over the next month following an elevated VIX level, the past data gives another very clear guide.
As you can see in the chart above, we are currently sitting in the 30-35 bucket. Historically speaking, when the VIX is sitting in this range, the odds favor it dropping by about 10% over the next month. In other words, given that the VIX is sitting at 32, the past 27 years of data would suggest that the average 1-month move from here is a drop of about 10% over the next month.
But are these charts accurate? Does the past give a decent guide to the future? I would argue that it does for two key reasons. The first reason is that the relationship is consistent and lines up perfectly with a fundamental understanding of the VIX. The VIX is essentially a trendless instrument – that is, it is an implied volatility calculation and its nature means that it responds to changes in options prices and options prices fluctuate around a mean over long periods of time.
And the second reason why I believe it’s good to ground our view using this type of historical analysis is that it has a proven track record of working. For example, last month I argued for more downside in the VIX based on our current levels as a starting point of analysis and we are moving towards the target established from the analysis of the VIX levels at that point. In other words, mean reversion generally tends to work – most of the time.
All this said, there are more facets of the VIX that we can study to generate a recommendation as per where we are likely headed. One of these predictive elements is the VIX futures curve itself. As you can see in the following chart from VIX Central, we are still in a small degree of contango on the futures curve in the front two contracts (the contracts UVXY holds).
The reason why it is important to monitor the percent contango or backwardation of the curve is that this relationship is directly correlated with future changes in the VIX itself.
For example, given that these last few trading days have seen VIX futures trading in around 5% of backwardation (negative levels on the chart), the past decade of data would suggest that the next 3 months will see the VIX drop by around 27%. In other words, the market structure is currently in a zone which historically precedes strong drops in the VIX as the market corrects.
We’ve covered a lot of ground here in examining the VIX, but here is the key message: the VIX is still very elevated both from an outright perspective as well as from a backwardation perspective. Market history strongly suggests that we are going to see the VIX correct further to the downside and the odds strongly favor a short position at this time.
Roll Yield
You really can’t leave a piece about UVXY without talking about roll yield because it is a very big deal in the volatility ETP space. Put simply, the problem of roll yield is that since you’re investing in VIX futures with UVXY, you're always exposed to how VIX futures move through time. This chart takes the last 10 years of data and shows the average difference between the first and second month VIX futures versus the underlying VIX by the day of the month (at the end of the chart, the front month contract expires and the second month contract becomes the front).
There is a lot of meaning contained in the above chart, so I would encourage you to examine this until it makes sense. But this chart essentially shows a few key things. First off, on average, VIX futures are in contango. That is, on average, the front month VIX futures contract is about 5-10% above the VIX and this percentage increases along the futures curve as contracts further back along the curve are priced higher than the VIX itself as well as proceeding contracts.
And the second and very critical thing to note here is that over a typical month, this difference between futures and spot shrinks or contracts. What this tangibly means is that on average, VIX futures are declining throughout most months as the futures price converges towards the spot price. This process is called “roll yield” since it is a unique source of return to holders of futures. What this means is that the return you get while holding futures contracts is subject to both the outright changes in the underlying thing the futures track as well as the losses or gains associated with futures contracts moving towards the spot price during a typical month.
What the above chart shows is that on average, investors in UVXY are losing to roll yield by around 5% per month – regardless of changes in the VIX. To help understand this, it pays to examine UVXY’s methodology. UVXY starts a trading month with about 100% of its exposure in the front month contract and every day moves a portion of exposure into the second month futures contract until the month is ended. This means that it is shifting exposure from the “M1 to Spot” line to the “M2 to Spot” line as a month progresses. And as you can see, these contracts are declining in value in relation to the level of the VIX – and UVXY has exposure to each.
There’s a lot of data in the chart above as well as the explanations, but the long-short of it is this: the methodology which UVXY tracks has declined at an annualized rate of 47% for the past decade as clearly seen in its methodology. Since UVXY gives a 1.5x leveraged return of this, historically speaking, an investment in UVXY has been virtually destroyed over lengthy periods of time.
For this reason, I suggest shorting UVXY with a long-term horizon. I would suggest doing this through options contracts to avoid the possibility of the market moving strongly against you. Even though the odds say there’s a 70% chance that the VIX is going to fall over the next month, if the market takes a hit, the VIX could climb once again – and since UVXY is giving a leveraged return of the percentage movements in the VIX (which itself is a percentage figure), an outright short could sharply move against traders.
I am short UVXY through puts out in 2022. It is my belief that the past represents a pretty good guide to the future and given that UVXY has a demonstrated track record of falling at an annualized rate of about 70% over the last decade, a short fairly far out of the money stands a good chance of being profitable as we progress through time.
Conclusion
The VIX is highly mean reverting and since we are at elevated levels, the odds favor further downside. VIX futures structure is currently suggesting that we are going to see further downside in the VIX. Roll yield continues to take a toll on the strategy which UVXY follows – I am short UVXY to capture the long-term returns associated with the roll.
