Long Volatility

[Horace Kent]

Recently, as we all are aware, the market has fully discounted planet earth and the human race surviving for the foreseeable future.

I caught a part of fast money on friday evening and Pete Najarian said something which caught my attention. That with the recent options expiry going off on friday, it means a lot of protection as expired. There are two ways to protect your profits - purchase insurance, or sell some stock. Combine that with the beating the VIX has taken - on friday, front month fix futures hit a low of 31.90 before rallying and closing over $33. I believe, for the time being (next week) that this is a bit too low considering the wreckage we've begun climbing out from under. I am well aware that a considerable amount of "protection" is indeed still in place considering that the bulk of hedging instruments are tied to the quarter end. That means the June futures are still front and center, as are the options tied to those contracts. Not to mention June equity options. Nevertheless, I believe volatility is due for a bounce.

Thankfully, there are now 2 relatively new ETNs (exchange traded note) that invest in VIX futures. The first VXX is the front month contract (don't quote me on that) and the second is the VXZ which is the mid-term VIX futures contract etn.

If the VIX rises 10% to 36 and change........something I don't see as too outlandish for the coming week, if stocks correct further, the ETNs should also rise 10%.

I'm going to follow these two much more carefully full-time because, since the notes themselves do not employ leverage themselves, on the surface, these two instruments "SEEM" (I can't stress that enough) like an excellent "long-term" hedges for a stock portfolio. Since you don't encounter the "leverage decay" like you would with the 2x and 3x inverse funds, again, it seems, like these should be a great pure play hedge that one could hold for a considerable amount of time.

These are new, so, the jury is still deliberating.

The main difference between an ETN and an ETF that invests in futures contracts is that you will have capital gains even if you don't sell the ETF. The capital gains the fund earns from rolling over each contract will be charged to you, even though you haven't sold it yet. An ETN, on the other hand, is treated like a pre-paid contracts, and are thus treated like a regular capital gain - when you sell out, that's when your capital gain is taxed - or due for the period in which the transaction took place.

There is one more risk. As its name implies, these are debt instruments issued by the backer, in this case Barclays, so.........if Barclays goes down, or could be close to going down, that will impact the pricing of the instrument.

Anyway.......I'm bullish on volatility for the upcoming week. If the VIX hits 36, I'll start peeling some off. That should take the VXX to the neighborhood of 90. I think it could go higher, but I can't see that far ahead.

Here's some links
VIX futures - http://charts3.barchart.com/chart.asp?sym=VIM9&data=A&jav=adv&vol=Y&divd=Y&evnt=adv&grid=Y&code=BSTK&org=stk&fix=

VXX - http://finviz.com/quote.ashx?t=vxx&ta=1&p=d

ETF vs. ETN - http://www.investopedia.com/articles/06/ETNvsETF.asp

VIX and More Blog with some concerns - http://vixandmore.blogspot.com/search?q=vxx
(good info here, that most likely burst my bubble.) Apparently, VIX futures are in contango much more than I originally expected - in which case VXZ "should" perform "better" or "closer" to an average of all the VIX contracts out there.


VXX info sheet and prospectus - http://www.ipathetn.com/VXX-overview.jsp

[Horace Kent]

I thought I'd check out friday's moves - the may and june VIX futures both were up a hair over 2.1% and 2% respectively, while the VXX was up 1.84%. I think the bulk of this is due to "smoothing" out of volatility expectations over time and the contango in the market. Each day the note sells some front month and buys the "on deck" month so, that compounds slightly over time. (see below for how the note creates a "30 day" exposure of VIX futures)


Some clarifications...VXX is a 30 day rolling ETN. By that I mean that each day barclays sells 1/30 of the front month futures contract and buys 1/30 of the "on deck" front month. So, VIX options expire on Wed of this week, that means on Wed. VXX will be 100% in the June contract. On thursday, it will sell 1/30 of that and roll it forward to July, and so on........each day.

One thing I'm beginning to not underestimate at all is that the Cash VIX is very much a real-time snapshot of the market, and as such, subject to some "quirks". Adam Warner (http://adamsoptions.blogspot.com/2009/05/never-trust-vix-over-30.html)sums it up well - Mean Reversion - "The shorter the volatility measure, the more noise you will see. Such as news anticipation, day or the week bias, et. al. Longer measures, be it a look at 90 or 180 day options, or VIX futures, or the VXX, smoothe it out and are often a better proxy for volatility expectations. None are *right* per se, I mean consider last Fall's volatility burst. The VIX shot up ahead of longer dated measures, but instead of reverting back down, the lift persisted and the longer term measures ultimately followed."

For this reason, you cannot compare the cash VIX to the VXX, or the VXZ! The VIX is a REAL-TIME measure of volatility happening RIGHT-NOW in the market place. This is important - if you're planning on purchasing an option - you know how the market is pricing volatility RIGHT NOW - thats when trades take place. Which is quite different from future expectations of volatility.

Bill at Vixandmore.blogspot.com lamented the fact that on April 20 - a day where the VIX spiked 15% - the VXX only rallied 7.4%. This is true! But, look at the May VIX futures contract - it only rallied 7.9%. Indicating that the VXX is tracking its target fairly well.

So, keep expectations in mind when dealing with this beast. Do not look at the VIX for how much these instruments should move. You need to look at the futures contracts underlying them, and take into account that the VIX is a real-time measure of volatility while the futures contracts "smooth" that out. I should point out - you can't trade the cash. The futures and options all deal with this....So, the VXX seems like a decent vehicle to trade and speculate with. If you have a futures account - trade the futures and avoid the expense. But, if these were around in early Feb. 2007.........I wonder how they would've done.....


With that said............if you are hedging a portfolio over say a year......I would also consider out of the money calls on the VIX futures. Bill at vix and more has some thoughts about that as well. But, for speculators, I don't see much difference between a vix futures contract and the VXX, aside from the leverage, and of course, the expenses.

[Horace Kent]

And, with all of this said...........I have to temper my expectations for a VXX rally this week, if indeed stocks continue the correction and volatility rises. If the VIX Cash were to rise 10% at any given time this week............I would expect June VIX futures, and therefore the VXX, to price in 70% (total guess) of that move (at most) and only move a possible 7%. Nevertheless, for the sake of argument, if the above is close to the ballpark, 7% isn't too bad a return.

What I haven't looked at deeper is returns vs. the market itself. In the above, I noted that on April 20th, when the S&P lost over 4%, the VIX cash was up 15%, and the VXX was up 7%...........What's interesting here is that the VXX almost doubled the inverse % move in the S&P..........without the leverage the 2x and 3x funds employ. So, in that respect, as a hedge on the broader market, for the last big down day we had.........the VXX seems like a worthy choice for a short-term hedging option, but at second glance a really bad one.

From April 9th to April 20th a time span where the S&P dropped 2.8% and what would look like via hind sight as an excellent hedging opportunity (using respective closes) the SDS gained 4.8% while VIX june futures and the VXX itself actually dropped 2.2%. Further, if you still had both hedges on, the SDS is down 8%, the VXX is down 18% during which the market is currently up 3% during this time frame.


So, for what we have data on........the VXX actually looks pretty crappy as a hedge. But, I wish we could go back to the late 2006/early 2007 time frame when the VIX was around 10 and compare that to the SDS if IT were around also. I'm thinking that starting from a historically low starting point for volatility may work as a better hedge than if you used the SDS..........I'm thinking a move from 10-80; 700% should do better than a double the inverse of an index that crashes 50% in a year.......But, I can't model that......and will probably have to wait 10 years or more to find out how the VXX will compare with the SDS.

I'm still interested to see how the VXX will perform from a "relatively" low level (under 20 preferably) vs. the SDS for the reasons mentioned above..........but, my suspicion is it will still under-perform.


Well, I hope you had fun watching me blow up a cute theory I had at the beginning of this thread.

Any questions??

[Stin]

Seems like a convoluted way to short the market. Also to be noted is that the vix is still near a historically high number so as a "long term" buy it might not play out that well.

Now as a hedge it might be really interesting to buy this around 10 to protect your long positions when times are good.

[Horace Kent]

Seems like a convoluted way to short the market. Also to be noted is that the vix is still near a historically high number so as a "long term" buy it might not play out that well.

Now as a hedge it might be really interesting to buy this around 10 to protect your long positions when times are good.

Basically, yes.

I'm interested in the VXX as a long-term hedge........an instrument that isn't subject to leverage decay, but also would react well over the short-term.

But, yes..........I still believe that had this ETN been around during late 2006 and January of 07 when the VIX was under 10........The VXX "should" have gone up around 500% or more during the "crash" of last fall. If that's right....It may work as a decent hedge that won't loose a lot of value due to time decay or leverage decay.