Focus Article: Trading the VIX

While working through the insider purchases from last week, I considered several companies as potential candidates for this week’s weekly focus article but came up short. The $1 million purchase by the Chairman of E*Trade (ETFC) was certainly interesting as was the $820,000 purchase by a director of The Cheesecake Factory (CAKE) but neither company felt like a screaming buy. This lack of a candidate combined with some business related travel last weekend is partially responsible for the delay in publishing the focus article this week.

We have in the past discussed hedging strategies to protect our portfolio through various strategies including the use of inverse index ETFs, put back spreads on overvalued momentum stocks as well as going long the volatility index. You can read our weekly focus article and special reports regarding hedging options here, here and here. While inverse index ETFs may provide ideal inverse correlation (they go up when the market goes down), the amount of protection offered during a sharp plunge may not be adequate unless you are using options.

There is a cost associated with hedging just as there is a cost for any insurance product that protects you from an unforeseen event. Options expiring worthless should the market stay flat or continue going up is one way you may end up paying for this protection. An inverse ETF like ProShares Short S&P 500 (SH) dropping in value is another way you might incur a paper-based loss if the market continues to go up. After trying various hedging options, I believe one good option to hedge your long portfolio could be the use of the Volatility Index or VIX as it is more commonly known. Given below is a brief discussion of the various VIX instruments, the problems that plague some of them and a strategy that could offset some of these problems while reducing the overall cost of hedging your portfolio.

CBOE Volatility Index (VIX) 15.96

The Volatility Index represents expectations of future market volatility and is also known as a fear index. At times of market turmoil, it spikes sharply higher and when the market is bullish or complacent it drops and stays low. The VIX briefly spiked to almost 80 in October 2008 during the dark days of the last financial crisis before falling to the low 20s just a year later. It spiked over 40 twice last Fall and dropped close to multi-year lows last Friday. One of my favorite trades last year was to short volatility using the inverse volatility ETN XIV every time it spiked over 35. After all one can only remain fearful for so long. Adrenalin along with the VIX is likely to subside after sudden bursts of fear.

This year, when the VIX dropped below 20, I went long volatility using the ETN VXX and closed it once for a small profit. When the VIX dropped again, I went long volatility using VXX in my long-term portfolio (held in retirement accounts) and by using call spreads in my trading account. With the market holding up well over the last few weeks, this position is now showing a loss not only on account of the VIX dropping to multi-year lows but also on account of an effect called “contango” (discussed below) that haunts products like VXX. If this alphabet soup has you confused, you are not alone. There are several instruments and strategies related to trading the VIX and I have attempted to highlight some of them in this article.

VIX Instruments:

It is not possible to directly buy or sell the Volatility Index and one can only go long or short the VIX by using options. Since options cannot be used in retirement accounts (beyond writing covered calls or cash secured puts) and because of other issues with options including time decay and high premiums, a number of products were introduced to allow traders to trade the VIX just like they would a stock or ETF. Some of these products were structured as Exchange Traded Notes (ETN) and allow you to go long, go short or take a leveraged position. Some of the more popular instruments are listed below,

1. Short-term long VIX: iPath S&P 500 VIX Short-Term Futures ETN (VXX)
2. Intermediate-term long VIX: iPath S&P 500 VIX Mid-Term Futures ETN (VXY)
3. Leveraged (2 times the exposure) long VIX: ProShares Ultra VIX Short-Term Futures ETF (UVXY)
4. Leveraged (2 times the exposure) long VIX: VelocityShares Daily 2x VIX Short-Term ETN (TVIX)
5. Short VIX: VelocityShares Daily Inverse VIX (XIV)

Tracking Error:

If you noticed, I included two options for a leveraged bet on going long the VIX. The reason for this is that each of these products suffers from serious tracking error. In other words they don’t actually mirror the performance of the VIX. There are days when the VIX might be up 7 or 8% and the long ETN VXX might only post a gain of 2%. The reverse also holds true, where I have seen a big drop in the VIX only translate to a muted gain in the inverse ETN XIV. This tracking error is magnified for the leveraged VIX products like UVXY and TVIX. As traders of TVIX came to find out earlier this year, other events such as the suspension or resumption of unit creation by the sponsor of the ETN can also dramatically lead to a drop in the value of these products that has nothing to do with the direction of the Volatility Index. To quote from the movie Fight Club, “On a long enough timeline, the survival rate for everyone drops to zero”. This is especially true for some of these products and is stated as such in their prospectus.

So why are these instruments best used as a short-term trade and why does this tracking error exist? The answer can be partially found in the aforementioned “contango”. Contango is described by Wikipedia as “Contango is the market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity. The futures or forward curve would typically be upward sloping (i.e. “normal”), since contracts for further dates would typically trade at even higher prices.” Products like VXX and TVIX attempt to emulate the performance of the VIX through a balance of front-month futures contracts and second-month contracts. Essentially as they get closer to the expiration of the front-month contract, they have to increase their exposure to the second-month contracts by constantly “rolling” front month contracts into second month contracts.

The opposite of “contango” is called “backwardation” where “the price of a forward or futures contract is trading below the expected spot price at contract maturity” according to Wikipedia. In other words the market expects future volatility to actually be less than current volatility. Backwardation doesn’t normally occur for physical commodities but has happened from time to time with VIX futures. So while Contango will hurt the price of instruments like VXX, backwardation could have a beneficial impact and may provide an additional boost beyond just a spiking VIX.

Call Spreads on the VIX:

Given some of the challenges associated with the use of instruments like VXX to hedge a portfolio from unexpected sharp drops in the overall market, is there a better way to hedge by using the VIX? I think the answer lies in using call spreads on the VIX. Call spreads are very similar to the put back spreads we discussed in detail last summer. To establish a call spread, you would sell an at-the-money or in-the-money call and use the premium generated from that sale to pick up two or more out-of-the-money calls. There may be times when you may have to put some money into the trade if the out-of-money calls are also expensive but for the most part, I have been able to establish both put and call spreads without putting much money into the trade. The other advantage is that your loss is limited to the difference between the two strike prices but your upside is large should the VIX spike sharply higher.

An example of such a trade would be to sell in the money $15 September calls on the VIX for approximately $4.50 and use these proceeds to purchase twice as many out of the money $18 September calls for approximately $2.55. In this trade, you would have to put in $60 per contract but if you selected $19 September calls for approximately $2.15, you would receive $20 per contract. Obviously your loss could also increase by using far out-of-the-money calls. Essentially by September, if the VIX is at or below $15, you would not lose any money. If it remains between $15 and $18, you would lose money with the maximum loss limited to $300 per contract. If the VIX rises above $18, your loss starts decreasing and everything over $21 is upside.

There are no free lunches in the market and as you can see from the example above, even with the use of call spreads, while you limit your losses, the VIX has to move up by more than 30% for you to start making money. With the VIX up nearly 9% intra-day today, a 30% move in about a month is not improbably and the whole idea of hedging is to protect against improbable events.

The choice of instrument and strategy you use, ultimately rests on your goals, your risk appetite and your conviction in your portfolio.