How Does XIV Work?

Tuesday, May 13th, 2014 | Vance Harwood

VelocityShares’ XIV and its sister fund ZIV are designed to go up when the volatility of the S&P 500 goes down.  XIV has a shorter time horizon (1 to 2 months) whereas ZIV has a 5 month timeframe

To have a good understanding of how XIV works (full name: VelocityShares Daily Inverse VIX Short-Term ETN) you need to know how it trades, how its value is established, what it tracks, and how VelocityShares (and the issuer— Credit Suisse) make money running it.

How does XIV trade?

  • For the most part XIV trades like a stock.  It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods.  With an average daily volume of 11 million shares its liquidity is excellent and the bid/ask spreads are a penny.
  • Unfortunately XIV does not have options available on it.  However its Exchange Traded Fund (ETF) equivalent, ProShare’s SVXY does, with five weeks’ worth of Weeklys with strikes in dollar increments.
  • Like a stock, XIV’s shares can be split or reverse split—but unlike VXX (with 3 splits since inception) XIV has only split once, a 10:1 split that took its price from  $160 down to $16. Unlike Barclays VXX, XIV is not on a hell-ride to zero.
  • XIV can be traded in most IRAs / Roth IRAs, although your broker will likely require you to electronically sign a waiver that documents the various risks with this security.  Shorting of any security is not allowed in an IRA.

How is XIV’s value established?

  • Unlike stocks, owning XIV does not give you a share of a corporation.  There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends.  Forget about doing fundamental style analysis on XIV.  While you’re at it forget about technical style analysis too, the price of XIV is not driven by its supply and demand—it is a small tail on the medium sized VIX futures dog, which itself is dominated by SPX options (notional value > $100 billion).
  • The value of XIV is set by the market, but it’s tied to the inverse of an index (S&P VIX Short-Term Futurestm) that manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts.  Every day the index specifies a new mix of VIX futures in that portfolio.  For more information on how the index itself works see this post or the XIV prospectus.
  • The index is maintained by the S&P Dow Jones Indices and the theoretical value of XIV if it were perfectly tracking the inverse of the index is published every 15 seconds as the “intraday indicative” (IV) value.  Yahoo Finance publishes this quote using the ^XIV-IV ticker.
  • Wholesalers called “Authorized Participants” (APs) will at times intervene in the market if the trading value of XIV diverges too much from its IV value.  If XIV is trading enough below the index they start buying large blocks of XIV—which tends to drive the price up, and if it’s trading above they will short XIV.  The APs have an agreement with Credit Suisse that allows them to do these restorative maneuvers at a profit, so they are highly motivated to keep XIV’s tracking in good shape.

What does XIV track?

  • XIV makes lemonade out of lemons.  The lemon in this case is an index S&P VIX Short-Term Futurestm that attempts to track the CBOE’s VIX® index—the market’s de facto volatility indicator.  Unfortunately it’s not possible to directly invest in the VIX, so the next best solution is to invest in VIX futures.  This “next best” solution turns out to be truly horrible—with average losses of 5% per month.   For more on the cause of these losses see “The Cost of Contango”.
  • This situation sounds like a short sellers dream, but VIX futures occasionally go on a tear, turning the short sellers’ world into something Dante would appreciate.
  • Most of the time (75% to 80%) XIV is a real money maker, and the rest of the time it is giving up much of its value in a few weeks—drawdowns of 80% are not unheard of.   The chart below shows XIV from 2004 using actual values from November 2010 forward and simulated values before that.


  • To be specific XIV does not implement a true short of its tracking index.   Instead it attempts to track the -1X inverse of the index on a daily basis, and then rebalances investments at the end of each day.  For a detailed example of what this rebalancing looks like see “How do Leveraged and Inverse ETFs Work?
  • There are some very good reasons for this rebalancing, for example a true short can only produce at most a 100% gain and the leverage of a true short is rarely -1X (for more on this see “Ten Questions About Short Selling”.  XIV on the other hand is up almost 200% since its inception and it faithfully delivers a daily move very close to -1X of its index.
  • Detractors of the daily reset approach correctly note that XIV and funds like it can suffer from volatility drag.  If the index moves around a lot and then ends up in the same place XIV will lose value, whereas a true short would not, but as I mentioned earlier, true shorts have other problems.  However daily reset funds don’t always underperform.   If the underlying index is trending down, they can deliver better than -1X cumulative performance.  For more see “A Hat Trick for Inverse / Leveraged Volatility Funds

How do VelocityShares and Credit Suisse make money on XIV?

  • Credit Suisse collects a daily investor fee on XIV’s assets—on an annualized basis it’s 1.35%.  With current assets at $600 million this fee brings in around $8 million per year.  That should be enough to cover Credit Suisse’ XIV costs and be profitable.  But even if it was all profit it would be a tiny 0.3% of Credit Suisse’s overall net income—$2.6 billion in 2013.  My understanding is that a portion of this fee is passed onto to VelocityShares for their technical and marketing activities.
  • I’m sure one aspect of XIV is a headache for Credit Suisse.  Its daily reset construction requires its investments to be rebalanced at the end of each day, and the required investments are proportional to the percentage move of the day and the amount of assets held in the fund.   XIV currently holds $600 million in assets, and if XIV moves down 10% in a day (the record negative daily move is -24%, positive move +18 %) then Credit Suisse has to commit an additional $60 million (10% of $600 million) of capital that evening.  If XIV goes down 10% the next day, then another $60 million infusion is required.
  • Unlike an Exchange Trade Fund (ETF), XIV’s Exchange Traded Note structure does not require Credit Suisse to report what they are doing with the cash it receives for creating shares.  The note is carried as senior debt on Credit Suisse’s balance sheet but they don’t pay out any interest on this debt.  Instead they promise to redeem shares that the APs return to them based on the value of XIV’s index.
  • Credit Suisse could hedge their liabilities by shorting VIX futures in the appropriate amounts, but they almost certainly don’t because there are cheaper ways (e.g., swaps) to accomplish that hedge.  ETFs like ProShare’s SVXY can use swaps also, but they often just deal with the futures.  The picture below is a snapshot of their holdings on May 13th,2014.  The parenthesis indicate a short position in the futures.

XIV won’t be on any worst ETF lists like Barclays’ VXX, but its propensity to dramatic drawdowns will keep it out of most people’s portfolios.  Not many of us can sit tight with big loses on the hope that this time will not be different.

It’s interesting that an investment structurally a winner albeit with occasional setbacks is normally not as popular as a fund like VXX that is structurally a loser, but holds out the promise of an occasional big win.

Slow and unsteady is trumped by a lotto ticket.


 For more information 

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Sell in May and Go Away—Not Good for Taxable Accounts

Tuesday, May 6th, 2014 | Vance Harwood

When I first saw a chart similar to the one below in Business Insider I was immediately suspicious.  For example I knew that May through September of 2009 was a period of rapid growth (21%) yet that surge did not seem to show up on the bottom curve (green)—which shows the performance of staying in the market only May through September.  

SIM 20yr-no-tax

It turns out the 21% gain is there, it’s just on such a low basis ($815), that it’s dwarfed by the other curves on the chart (one of the dangers of a chart with linear vertical axis).

My analysis didn’t include dividends nor did I factor in interest that could have been earned while out of the market.  I think these two factors would roughly offset each other with the in/out strategies, and including dividends would have boosted the gains of the “always in” strategy.

I also wondered about the choice of 1994 as a starting point.   A 20 year time frame is reasonable, and 1994 wasn’t a particularly eventful year, but I repeated the analysis with 63 years of S&P 500 data to see if it made a difference.

SIM 50yr-no-tax

Over this timespan the “Sell in May” strategy significantly lagged in the bull markets of the late nineties and 2002 to 2007, and catches up during the depths of the bear markets.

The hold May through September strategy is still a flat-liner.  It’s hard to see how being in the market during that period helps the buy & hold strategy.  A closer look at the yearly distributions yields the answer.

The chart below shows the distribution of the percentage gains/losses by year being invested only May through September.

SIM 50yr-rtns-IMS

The average of all the returns is low—a paltry 0.33% yearly gain, but the number of up years out numbers the down years by almost two to one, 40 up years vs 23 down years.

The next chart adds the results (green bars) of being invested except for May through September.

SIM 50yr-rtns-both

 There were only 10 years during this 63 year period where losses during the May through September period weren’t more than offset by the returns from the rest of the year.  And in 33 of those years both periods had gains—dramatically compounding the results.   It’s this compounding effect that rewards the buy and hold investors.

This final chart shows the performance of the “Sell in May and Go Away” strategy with taxes included, assuming a 28% marginal tax rate.

SIM 50yr-w-tax

Since the strategy is never invested for a full year taxes on profits will always be at short term capital gains rates—typically the same as your marginal tax on income.   Since you don’t have to pay taxes on gains until the year after you sell the security I assumed that the money earmarked to pay taxes was used for ongoing investment until early April of the next year.  Losses were carried forward and used to reduce/ eliminate tax on latter gains.

Including taxes the results of the 63 year “Sell in May” strategy were hammered down 70%—from $100K down to $30K and the 20 year period takes a 30% haircut.  So, unless your investments are in a tax protected account the historical performance of this strategy would have been abysmal.   Even in non-taxable accounts the long term performance of “Sell in May” would have been inferior.

I think it’s best to stay away from “Sell in May”.

Modified Davis Method Moves to 50% Cash

Sunday, April 13th, 2014 | Vance Harwood

The market stumble the end of last week dropped the Russell 2000 enough for Frank Roellinger’s Modified Davis Method to signal a 50% sell.  That portion of the portfolio gained 17.6% since being opened 30-November-2012.  This exit was foreshadowed in the Modified David Method-March 2014 Update 

The other half of the portfolio, initiated in July 2009,  is still long with a 57% open gain—market breadth has not diverged enough to trigger an exit.  

Thirteen Things You Should Know About Trading VXST options

Thursday, April 10th, 2014 | Vance Harwood

If you want to trade options on VXST I’ve listed some things below that you should know.  If you are interested in other volatility investments besides options see “10 Top Questions About Volatility“.

 Regarding VXST options:

  1. Your brokerage account needs to be a margin account, and you need to sign up for options trading.   There are various levels of option trading available (e.g., the first level allows covered calls).  My experience is that to trade VXST options you will need to be authorized to trade at the second level.  These levels vary from brokerage to brokerage, so you will have to ask what is required for  long or spread positions in VXST options.   If you are just getting into options trading this is as high as you want to go anyway. Selling naked calls for example is not something for a rookie to try.
  2. No special permissions are required from your broker for VXST options. In general the same sort of restrictions (e.g., selling naked calls) that apply to your equity option trading will apply here.
  3. Calendar spreads aren’t allowed (at least within my account, with my level of trading). The software might not prevent entering the order, but the order will be cancelled once your broker’s software gets around to analyzing the order.   The reason for this restriction is because the options from different months don’t track each other well. More on that later.
  4. The option greeks  for VXST options (e.g. Implied Volatility, Delta, Gamma) shown  by most brokers are wrong (LIVEVOL and Fidelity are notable exceptions).  Most options chains that brokers provide assume the VXST index is the underlying security for the options, in reality the appropriate volatility future contract is the underlying. (e.g., the options expiring the second week of April have the second week of April VXST futures as the underlying).   For instructions on how to get VXST futures quotes go this this post.   To compute the correct greeks yourself go to this post.
  5. Because the underlying for VXST options is the futures contract, the options prices do not track the VXST particularly well.  A big spike on the VXST will be underrepresented, and likewise a big drop probably will not be closely tracked.   This is huge deal. It is very frustrating to predict the behavior of the market, and not be able to cash in on it.  The good news is that with the VXST shorter expectation horizon (9 days) at least we have something more responsive that VIX futures / options. The only time the VXST options and VXST are guaranteed to sort-of match is on the morning of expiration—and even then they can be different by a couple of percent.
  6. The VXST options are European exercise. That means you can’t exercise them until the day they expire. There is no effective limit on how much VXST options prices can differ from the VXST index until the exercise day.
  7. Expiring In-the-Money VXST options give a cash payout.  The payout is determined by the difference between the strike price and the SVRO quotation on the expiration day.  For example the payout would be $1.42 if the strike price of your call option was $15 and the SVRO was $16.42.
  8. The expiration or “print” amount when VXST options expire is given under the ^SVRO symbol (Yahoo) or $SVRO (Schwab).   This is the expiration value, not the opening cash VXST on the Wednesday morning of expiration.  VXST options expire at market open on expiration day, so they are not tradeable on that day.
  9. VXST options do not expire on the same days as equity options. It is almost always on a Wednesday before or after the Friday equity option expiration date.   This odd timing is driven by the needs of a straightforward settlement process.  On the expiration Wednesday the only SPX options used in the VXST calculation are the SPX weeklies that expire in exactly 9 days.  For more on this process see Calculating the VIX—the easy part.
  10. The bid-ask spreads on VXSToptions will tend to be wide .   You should be able to do better than the posted bid/ask prices.  Always use limit orders.  If you have time start halfway between the bid-ask and increment your way towards the more expensive side for you.
  11. I don’t recommend you start trading options on VXST if you aren’t an experienced option trader. If you are a newbie trade something sane like SPY options first…
  12. The VXST is not like a stock, it naturally declines from peaks. This means its IV will always decline over time. VXST options as a result will sometimes have lower IVs for longer term options—not something you see often with equities.
  13. The CBOE reports that trading hours are: 7:30am to 4:15pm Eastern time, but in reality the options do not trade until after the first VXST “print”-when the VIX value in calculated from the first SPX options transactions. The first VXST quote of the day is usually at least a minute after opening.


Guest Post: Modified Davis Method—March 2014 Update, by Frank Roellinger

Saturday, March 29th, 2014 | Vance Harwood

It’s been about 7 months since my first article on The Modified Davis Method appeared, so it’s time for an update.  Here is the original chart updated through 3/28/14.  As before, the top (white) line is the method’s results; the yellow line is the Value Line/Russell 2000 series; the green line is the S&P 500 for reference.


The method is still 100% long after the last buy on 11/30/12 when the Russell 2000 closed at 821.92.  Since then the ETF that tracks the Russell 2000 (IWM) is up more than 42% with dividends reinvested.

The following chart illustrates the method’s computed potential exit points since the Buy on 11/30/12.  The upper line is the weekly close of the Russell 2000 index; the lower line depicts the exit points each week.  The method has remained 100% long in the Russell 2000, despite several pullbacks and the usual plethora of predictions that the market is overvalued and cannot go much higher.


Additionally, the original 4% method would have exited and reentered 3 times during this rally, greatly reducing the gain compared to remaining 100% long.  Searching for thresholds other than 4% and employing the dynamically-adjusted trend line have payed off handsomely this time.

The stop was just barely missed on 02/07/14.  Since then, the stop has risen more than 23 points and is still rising.  The method’s use of breadth suggests that the final top has not been reached.  But, sooner or later an exit point will be breached, and soon thereafter, it will be reported here.

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