Search This Blog

Monday, May 17, 2010

Now That We Understand A Bit More About VIX, VIX Futures VXX and VXZ (from the last post) How Best to Use VXX and VXN

Whar are the implications for the market outlook of the analysis in the previous blog for the "real world" of the markets:

It seems the market anticipates near term volatility no doubt on the downside in particular.

As for those watching the vix, vxx and vxz:

The period since the introduction of the vxx have no doubt been extremely painful and frustrating for those that held it. Since the vxx represents the near term future and the contango was very large the vxx suffered large losses due to the cost of rolling futures contracts as they expired. Hence the sharp decline in the vxx far more extreme than the cash index. As for the vxz the losses were less extreme becuase of the less extreme curve between the mid date futures it represents and the less frequent roll trades.

But judging by much analysis I can have seen people have thrown in the towel on the vxx based on the short time period since the instrument has started trading. As seen in the table above as the vix increases to extreme levels the curve of term strucutre fkips, In other words the holder of the vix gets an extra boost in return just when he wants the hedge to be most effective.

Effectively the time decay of option premia hurt the vxx far more than the vxz. And the vxx is more sensitive to changes in the vix than is the vxz.

This differential means that the vxx is far more sensitive to changes in the vix than the vxz. The "hedge ratio" ration of price change in the etn relative to change in the far higher for vxx to vxz.

As volatility and the vix increased massively over recent trading days this was readily apparent the long suffering vxx holder saw their positions increase a multiple of the vxz and a large multiple of the actual volatility in the s+p 500 and by extension the global equity markets. Those looking for a 1:1 movement between the vix and one of the etns were disappointed but they were looking for the wrong result. The etns are linked to the future not to the vix which is an index and cannot be traded.

The correct way to look at these instruments is either as a hedge of a long equity position or a trade.  Since volatility is more extremen on the downside, the vxx or vxz position would offset those losses  And the instruments performed extremely well  the vxx for instance on friday moved  the percentage move in the sp 500, the vxz moved . Furthermore with the flip in the futures curve from contango to backwardazation the vxx will likely suffer little or no loss when rolling contracts/

So what is the bottom line for use of the vxx and vxz:

They should be viewed as a way to offset the actual volatility of the S+P 500 either as a trade or a hedge.

Traders should look to the vxx which has a higher leverage to the underlying moves but a slow market will translated to a far steeper decline in value. The volatility of volatiliy is far higher for the vxx. But the leverage of the vxx is quite large recently it moved 4-5x the move in the sp 500

Those looking for a longer term hedging vehicle should look to the vxz. Recently it moved around 2x the move in the sp 500.

Using the above numbers one could argue that a 20=25% position in vxx would offset all of the loss on a stock portfolio during turbulent times. For vxz it would be closer to 50%.

This instrument has an  added benefti. In a turbulent down market we have observed two things:

volatility spikes increasing the leverage of these instruments
Among equtiies diversification becomes weaker and "the only thing that goes up in a down market is correlation". So these instruments provide a hedge (although of course of not identical efficacy ) of the non US parts of an equity portfolio as well as the small cap US despite the fact the sp 500 is large cap US stocks

Here are 3 mos graphs of the vxx(top) and vxz note how painful the futures roll has been for longer term holders of the vxx while recently the market has been more favorable to vxx over vxz holders.

So what would be the optinal strategy for those that want to hold a black swan hedge in their portfolio ? A longer term position in the vxz an addition of vxx position or a partial swap from vxz to vxx in anticipation of higher volatility in the market and a reversal of the position during a time of market stability. Of course the likelihood of getting that timing right is as great as the likelihood of timing any other market. But a mix of a larger position in vxz combined with a smaller proportion of vxx probably the best approach with the caveat to avoid the vxx completely when the futures mkt is in deep contango.

No comments: