In a recent podcast episode on BetterSystemTrader, New Zealand investor Andrew Gibbs talks about an easy and ‘almost foolproof’ strategy for trading the VIX (ticker symbol for the CBOE Volatility Index).
If you don’t know, the VIX is a futures contract that measures implied volatility in the equity options markets. It’s also known as the fear index because when the stock market crashes the VIX shoots up and when the stock market rallies the VIX dies back down. The VIX hit a high of 48 during the 2010 flash crash and jumped over 80 during the 2008 credit crisis.
While the VIX shoots up during times of panic, it usually resides at lower levels, typically between 10 and 20 during calmer times. Thus it makes sense to short the VIX ETF during times of panic and buy it back when the markets are more calm. Thus, the strategy is to sell volatility. And there are a number of financial instruments that let you take on this trade, including the VIX future itself.
However, Gibbs says that rather than short the VIX future, it can be better to trade one of the ETNs (Exchange Traded Notes) that allow investors to take long or short positions in the index itself.
One popular method for selling volatility is to short VXX which is the iPath S&P 500 VIX ST Futures ETN. Essentially, the VXX ETN tracks the VIX so if you expect markets to encounter extreme volatility in the short-term, then buying VXX can be a good strategy.
However, there is a major problem with buying VXX on any medium or long-term timeframe because it is a product that experiences extreme value decay over time. Because of the way the ETN is constructed, it experiences significant contango loss, whereby it typically loses 5% in value every month. This consistent poor performance is clearly visible by consulting the monthly chart below:
Another problem with the VXX is that it struggles to match the VIX anyway, and on average VXX only moves 55% as much as the VIX future.
Because of these major disadvantages, an increasingly popular strategy among sophisticated investors is to go short VIX by shorting VXX. By doing so, you make money when the VIX falls but you also make money from the contango loss. In some respects this is a sure-win bet and some traders seem to be doing this on a regular basis.
However, just because this strategy is almost foolproof, in the long-term there are still significant risks that some investors may overlook.
First of all, going short the VXX can be a very high risk play if you are under-capitalised, since a spike in the VIX would lead to a massive jump in VXX as well. This spike could easily cause drawdowns of 80%+ and lead to a margin call on your account. For this reason, you need to be extremely careful when taking a short position and make sure you have enough margin to cover a sudden surge in volatility. A move such as the 1987 stock market crash would surely wipe many VXX shorts out.
Secondly, ETNs are still not particularly well understood and there are some risks involved with the ETN itself. For example, the ETN could break, and this has happened before.
There is also the possibility of higher interest rates and backwardation that could cause the costs of shorting VXX to change. (When you short VXX you will need to pay borrowing costs, just like a stock, and this means you will need to factor this into your calculations.)
Thus the opportunity to short VIX by shorting VXX is not always straightforward. And since this strategy is becoming relatively popular there’s a chance that it could be becoming a crowded trade as well.
What about XIV?
Since shorting VXX has logistical difficulties, I propose that a better alternative is to buy (go long) it’s opposite – XIV. XIV is another ETN but it’s actually the inverse of VXX so when you buy XIV you are essentially shorting XVV but without any of the hassle that comes with it. By purchasing XIV then, you are selling volatility (selling the VIX) as well as making money from the VXX contango loss. But you are doing it by purchasing the XIV ETF!
Thus, a good strategy is to go long XIV after the market has crashed and add to the position during market corrections. (I believe this is the strategy that Andrew Gibbs is talking about).
Risks with XIV
Going long XIV has some risks attached too. Just like VXX, you can experience a large drawdown during a stock market crash and backwardation could cause short-term losses.
However, unless you think the world is going to end, XIV seems like a solid investment especially during times of market panic.
Indeed, let’s say that your strategy is to purchase XIV with $1000 every time the VIX spikes above 25. If you had done so over the last few years you would have almost doubled your money.
With this strategy you would have made 10 trades since 2011, investing a total of 10,000 before fees. (By the way, 2011 is when the ETF was created so we can’t go much further back than this).
So, between 1/1/2011 and 1/1/2016, you would have made a net profit of $8,827.80 turning your $10,000 into $18,827.80. This equates to a compounded annual return of 13.97%.
The equity chart below shows that the strategy is currently in a drawdown as a result of the increased volatility we have seen recently in the stock markets.
So, whether you base your strategy on the VIX crossing 25 or not, buying XIV during times of market volatility seems like a good strategy to pursue. The markets will rise and they will fall, but unless the world is coming to an end, volatility will eventually give way to calmer times.
Simulations in this article created with Amibroker using data from Norgate Premium Data.