Confidence runs high; I’m Vix’ed out

Maybe I’m a one-trick pony.  I just happen to like playing the Vix – in particular, the Vix-related derivatives.  There are 2 main ways I like to do this:

  1. Just short it: I take advantage of a few related characteristics to short the Vix via UVXY.  In particular, I like that UVXY is the prototype of a bad long-term buy, so I short the product using medium-dated options.  After biting my nails during the past couple months’ market volatility, this trade finally hit pay dirt.  I’m out of my latest iteration as of today, after holding about 2.5 months.
  2. Spread it: when the markets get really scared, the Vix futures curve looks like the red line below (from previous post):
    Mmm...backwardation.  Source: thinkorswim by TDAmeritrade

    Mmm…backwardation. Source: thinkorswim by TDAmeritrade

    Today that red curve looks much more normal, as we’re back to daily all-time highs:

    All back to normal.  Source: thinkorswim by TDAmeritrade.

    All back to normal. Source: thinkorswim by TDAmeritrade.

    I took off the latest iteration of this trade yesterday.  About 3 weeks of holding time.

What have I learned?  First, it’s great to learn with successful trades.  My theses were researched and executed when the time was right.  Most importantly – in my mind – is patience: at one point I was looking at some pretty solid losses on the #1 trade as the Vix kept climbing higher.  Nevertheless, that’s why I chose medium-term options to express the trade, and ensured I had a manageable maximum loss at initiation of the trade.

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VIX futures calendar spread strategy: a little data mining

Has anyone noticed a bit more volatility in markets these days?  That SNB shocker was something, indeed – it seems some FX retail brokerage houses have already declared insolvency.  Anyway, the increased volatility has had quite an impact on VIX in the year so far: after starting the year at an elevated, yet respectable 17-ish, the index has climbed to a panic-like 22.5.  For those stats-minded, that latter figure implies a daily move of around 1.4% for the SPX – not unusual recently, but pretty darn high compared to post-2008.

OK, let’s get to work.  The VIX is very elevated, but it can be a mug’s game to short (i.e. the VIX can get smashed a bit like the SNB smashed the Euro/CHF exchange rate yesterday).  Too risky for an outright short.  What to do?? A VIX calendar spread.

Mmm...backwardation.  Source: thinkorswim by TDAmeritrade

Mmm…spot the backwardation. Source: thinkorswim by TDAmeritrade

  • Hypothesis: times of high volatility causes the VIX futures curve to go from contango (e.g. further months more expensive than near months) to backwardation (the opposite).  When the market returns to more normal conditions, the contango will return.
  • Method: when the futures curve goes to backwardation, or very near it, go short a near-month future and hedge by going long a further-dated future.  Take off the trade when contango returns.
  • Which contracts?  Note the curves in the picture.  The red line is today’s VIX futures curve – e.g. flat to backwardated.  The other lines are the month-end VIX futures curves for the past 6 months.  A couple observations:
    • In normal markets, there is a pretty smooth contango.  So the max return for any 1-month calendar spread is about the same going out 6 months.  You could choose, say, months 2/3, 3/4, etc.
    • However: notice how much extra movement occurs in months 1 & 2, say, relative to further months.  So, it’s a risk/return situation: if you want higher risk/return, go for earlier months.  I, being a chicken, will stick with a bit less risk – months 3/4, perhaps.  That means I choose to be short Apr 2015, hedged by long May 2015 futures.
  • A bit of data mining to convince me: I downloaded the month 3 and 4 continuous contracts from Quandl, then did the following rough analysis:
    • Time range: 1 Jan 2008 through yesterday, daily data.
    • Metric: gross profit from Month 3 and 4 calendar spread, assuming a 1-month hold (i.e. mechanically holding the position 1 month).
    • Brief, dirty stats:
      • Unconditional (e.g. all daily observations)
        • Observations = 1740
        • Mean gross return = $0.006/spread
        • Expected return, using uniform probability distribution and decile returns (including min/max) = $0.033/spread
        • Z-test for mean different than 0 = 36.8%.  In sum, I can’t assume the expected return is positive.
      • Conditional (e.g. only enter trade when spread is $0.05 or less)
        • Observations = 454
        • Mean gross return = $0.341/spread
        • Expected return, same method = $0.320/spread
        • Z-test for mean different than 0 = less than 0.01%.  In sum, I can assume a positive return.
  • Summary: I think this strategy will work in the current environment, so I’ve put on the trade in small size to test the waters.  Wish me luck!

Let there be…vol?

Will there be calm, or more party time?  Source: Google images

Will there be calm, or more party time? Source: Google Images

So this is probably the last ‘serious’ week for financial markets of 2014.  Some thoughts:

  1. Is oil done?  The news seems more bent on $40/barrel oil, or at least $50, so another 10-15% down move from here.  I’m sure many recognise that the media is generally way late to the party, so perhaps today’s slight recovery to above $58 is putting in the near-term floor.  My momentum models don’t care about the debate, and are staying well-short.
  2. Which is right: VIX or S&P?  Last week’s rise in the VIX, from about $12 to about $19, was an outlier move – similar to what happened last October.  So are we due for an exciting, proper sell-off in the S&P?  Or is this morning’s resilience in the index (up about 1%), combined with VIX selling off (down about 3%), the more relevant fact?  On Friday I reloaded on my old favourite UVXY trade, so I’m clearly hoping the latter.
  3. I feel bad for being long grains.  My same momentum models have me long soybeans, which has been a pretty good trade so far.  However I can’t ignore the oversupply, which I hear from family in the Midwest.  Another example of how the biggest enemy to a systematic trading approach is probably manual intervention.

In sum: I’d like a quiet week.  My models would prefer a chaotic week – or at least a continuation of that lovely oil trend.  With the remaining economic news of 2014 released this week, combined with rolls/option expiry, I’m guessing there will still be plenty of action.

Why I love leveraged ETFs/ETNs…particularly UVXY

In a phrase: vol drag.

Volatility drag (‘vol drag’) is a product of compounding a return series which is multiplied by a constant.  In the case of UVXY, the return series is the movement in the VIX index, which is in turn a measure of S&P 500 30-day implied volatility.  The ETN aims to provide 200% of the daily change in the VIX index.

The immediate appeal of the product seems easy, at first glance: the VIX tends to move in opposite direction to the S&P, so why not buy VIX to hedge an equity portfolio.  While I’m at it, why not cut my hedging costs by buying a 2x version of the VIX?  Well, that’s where vol drag comes into play.

It’s important to mention that UVXY was, apparently, never created for investors holding more than 1 day.  Why?  Well, the first thing to mention is the VIX, like almost all underlyings, moves up and down: there is no smooth path for the VIX:

Screen Shot 2014-08-27 at 10.41.31

In fact, the VIX moves a lot: realised volatility for the VIX is around 125% these days, or around 8-10x the volatility of the S&P.  When we multiply that return series by 2, we increase the daily volatility by the same factor.  When we compound those returns daily, to make the price series for UVXY, we find a significant drag.  The difference between arithmetic returns (e.g. the 2x daily return achieved by UVXY) and geometric returns (e.g. the UVXY price series, which is a daily-compounded return series) is equivalent to 50% of the variance of the underlying (VIX), which is a big number.  See here for more explanation.

There’s another reason I love UVXY, which is persistent futures contango.  Because the VIX is not directly investable, UVXY invests in a combination of front & 2nd month VIX futures to achieve its objective.  The persistent contango is, ironically, likely a result of so many folks buying VIX ETFs/ETNs – more equity hedgers than speculators.  Anyway, because later-dated futures contracts cost more than nearer-dated, or indeed cash VIX, UVXY (and other VIX ETNs) have a persistent negative drag from the contango.

How does it all add up?  Here is YTD for UVXY versus its underlying, the VIX index.  A reminder: the objective of the ETN is to provide 200% of the daily return of the VIX; the persistent decay of UVXY is due to the factors explained above (in addition to a third, small, factor: a 0.75% annual management fee):

Screen Shot 2014-08-27 at 10.58.23

So, what to do with this?  The main risk to mention with UVXY is massive skew and kurtosis: that is, the very real risk for a large upward move when the VIX spikes.  So while I look at a picture like the above and say ‘Go short!’, I think back to times like 2011 where UVXY explodes both because of a spike in VIX, and because of a swift change in futures contango:

Screen Shot 2014-08-27 at 11.02.22

Yes, UVXY can blow up.  So, the answer is a combination of going short UVXY with buying upside protection.  If the protection can be bought reasonably (it usually can), and the investor can stomach the big jumps (knowing max loss from inception is helpful here), it seems a good trade.  Extra credit: wait for a VIX spike before opening a trade.  

(Source for charts was Google Finance)