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Wednesday, May 12, 2010

Black Swan /Volatility Hedge Update

The strategy of buying volatility etns has worked well during the current downturn. Since april 30:

VXX short term vix futures etn +31.5% (top leftt chart)
VXZ meditum term futures vix etn +11.5% (top right)
vix index  +28.4% (below left)
s+p 500  -2.5% (below right)

Clearly the black swan hedge with the etns has worked well

A couple points of note

  • . A quick google for VXX will lead many articles decrying the vxx as a terrible instrument that doesnt give the holder benefit when volatility increases. They fixated on  recent  past performance, never a good practice in investing  An example of this is from an "expert" on etns and etfs at the "authoritative" index universe website  who wrote on april 26

But neither the ETNs nor the proposed ETFs will fully benefit fully from any rebound in the VIX. That’s because the market for volatility futures right now is already pricing in the likelihood that volatility will be higher tomorrow than it is today. The Spot VIX is currently trading at 16.62, while May futures are priced at 18.50. In order for VXX (which currently holds the May contract) to appreciate in value, spot VIX must rise above 18.50 next month. In other words, investors need an 11 percent increase in volatility next month just to break even!

It gets worse in July, where the futures are pricing in a VIX of 20.75.

Well the vix is at 28.32 , the vxx is at 25.63 and the long vxx position returned 37% in the 2 weeks since that post more than overecoming what he saw as the insurmountable premium between the spot index and the futures.  And that differential between the spot vix and the july futures (even worse)  that he pointed out on april 26 ? The market has now flipped with the cash vix at 28.32 and the july futures at 27.10 (more on that later)

Seems to me this writer and others missed the whole point of owning the vxx. It is something designed to make money in extreme market turbulence. Judging its efficacy and writing it off based on how it disappointed during a stable market is, to put it charitably premature. The instrument wasnt around during the fall of 2008 but imo it performed quite well during its first test in extreme market turbulence.

  •  The short term etn the vxx is more sensitive to changes in the and actual market volatility. It will generate a return that is a higher multiple of the decline in the stock market. It is a more leveraged hedge but it will also drop far more sharply in response to drops in the vix and lower actual volatility
  • . The vxz based on the medium terms futures is a less leveraged hedge it also drops in price slower in response to falls in actual volatility and the vix

  •  The above makes the vxx more of a short term play on volatility the vxz more of a longer term hedge agains the black swan. IMO under current conditions some of the vxx should be held in addition to the longer term vxz hedge position.

  •  One thing that has bedeviled holders of the vxx in the past has been the cost of the "roll " of the futures on the value of their position. This can bee seen by the steady decline in the value of the vxx far more than the underlying index the vix.

This is because the vixx represents a long position in the near dated vix futures. As the futures approach expiration the etn provider must sell the futures nearing expiration and buy the next date futures. For most of the history of the futures index the market has been in "contango" the near date futures traded at a discount to the futher out date makin the roll costly often in excess of 10%.

The chart below illustrates the difference between the may and june futures and reflects the patterns between near date and next date futures contracts. A positive number means the june futures costs more than the may futures, meaning that the "roll" selling the near futures and buying the next date resulted in a loss. This dragged down the value of the vxx contract. More data on this can be found a this paper from S+P here

Now look at what has happened in the last week. The further date futures had moved to a discount to the expiring future (june is chearper than may) this reflects high demand for near term futures. This is exactly what happened during the fall of 2008 (black swan event) when the near date futures reached a premium of 20% over the further out dates (see the s+p paper). A fellow blogger gives a good explanation of the roll factor here although i dont agree on his conclusion about not using the vxx

What it means for vxx holders is that they are no longer penalized each time the ertn provider must "roll" their futures position. In fact what had been a drag on performance may in fact add a bit to the returns of the contract. In any case it means there will not be as large disconnect between the changes in the value of the vix and the vxx.

It also means that those long the vxx going into an extreme period of actual and implied volatility get an extra boost to the appreciation of their position as the futures curve shifts to backwardation (near date premium to far date futures) instead of the opposite = cotango.

Interestingly this movement also belies the conclusions of many in the blogosphere argued against every owning the vxx. As volatility goes to extremes the futures curve flips yielding a bit of a windfall gain as the futures are rolled. In other words when things get bad for those short volatility either literally or methaphorically those already long through the etns reap the benefit. The same thing happened in the futures in the fall of 2008. But since this was before the advent of the vxx etn, it seems many analysts discounted this happening. It is a "black swan" in the volatility futures market to coincide with the "black swan "in the underlying market.

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