DIA Dividend Capture Using XVZ as a Hedge

Thursday, February 9th, 2012 | Vance Harwood

DIA goes ex-dividend next Friday the 17th.   The dividend history on this ETF  (see below) suggests that the dividend will be around $0.30 per share.   I put a dividend capture position in place buying DIA at 128.68 and selling-to-open the 18-Feb S127 calls for 2.09 for a net debit of 126.59.

The calls only provide a 1.5% downside cushion on the position, so I further hedged the position by buying Barclays’ XVZ in the ratio of $1 of XVZ for every $3 of DIA.  This is the hedge ratio that I backtested in this post that historically would have done a good job of protecting a general equity position like SPY or DIA.

If the S127 calls stay significantly in the money then they will be assigned next Thursday night and I will keep the option premium, but won’t get the dividend.  If DIA drops below 127 then the options probably won’t be assigned and my breakeven point drops by the dividend amount received.

DIA dividend history

To generate dividend history reports like this for all SPDR and iShares ETFs see this post.

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When Will This Bull Run Be Over? Using the VIX / VXV Ratio as an Indicator…

Wednesday, February 8th, 2012 | Vance Harwood

If you can remember market action for more than two months, you’re probably not wondering: “Is Market Volatility Gone for Good?”  However you probably are wondering when this sustained upswing will be over.   I’m keeping a close eye on things because I’ve had a run-up in my VelocityShares XIV holdings that I’d rather not lose to a correction.

The last few months have felt like the market a year ago, when the market had a sustained climb.  The chart below confirms that SPY is following a similar path—the dotted lines are last year’s data.   The orange vertical line marks when the market shifted into a choppy sideways phase last year.

Predicting a market change is notoriously hard.   Since it is driven by options premiums, and options traders are theoretically more sophisticated than standard equity investors you might expect the VIX index to move before the market—but it doesn’t.   The chart below shows how the VIX bump (black line at bottom) lagged the the 18-Feb-2011 market shift by a couple of days.

SPY & Volatility, Now and a Year Ago

The trace around 90 shows the VIX/VXV ratio multiplied by 100.   The VXV is a CBOE  index similar to the VIX that projects volatility out 3 months instead of  the VIX’s 1 month time frame.  A magnified version of the chart is shown below:

 

A closer look at the VIX/VXV ratio

The VIX/VXV ratio shows an interesting little bump above 0.9  just a few days before the correction.   The VIX index moved up slightly on those two days—it’s not readily apparent on the VIX chart, but the VXV didn’t move up as much, and as a result the ratio bumped up.   The bright folks at Barclays use this VIX/VXV ratio as the master control for allocating volatility assets in their XVZ volatility ETN.  When the ratio climbs to 0.90 or above they decrease their allocation into short volatility.

The chart shows that the VIX/VXV ratio rose above 0.9 several times in 2011 before the correction—false alarms.  However those bumps were accompanied by relatively big moves in the VIX index.  It could be that the VIX/VXV ratio bumps that aren’t associated with significant overall jumps in volatility might be the signals to really watch.

I fully expect the VIX/VXV ratio to sound some false alarms in the future, but when it says the risk is low, with levels below 0.9,  I’m inclined to relax.

The market closed today with a VIX/VXV ratio of 0.878—I guess I’ll hold inverse volatility a bit longer.

 

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Trading ETFs Without Getting Fleeced

Tuesday, January 31st, 2012 | Vance Harwood

There are over 1300 ETFs right now, with another 900 in registration. This explosion of alternatives is great for driving down fees and giving investors choices.  However once we figure out what we want to buy, we often discover the fund we chose is lightly traded—perhaps only hundreds of shares are traded on any given day.

With a lightly traded fund the bid/ask spread is usually significantly wider than the one cent spreads we see with the big ETF funds and stocks.  The thumbnail below (click to enlarge) is from Fidelity Active Pro’s order book of Barclays’ VQT.  The fund has almost $200 million in assets under management—but its order book is still ugly.

Order Book for VQT

The best quoted  bid/ask spread is $0.08—not great but only a 0.06% hit on the overall value of the trade.  However, those quotes are only for 100 shares.  For 200 shares the spread widens to $0.44, and for 1000 shares the visible book widens to 125/129.54—a chilling $4.54 spread.

If someone was careless enough to enter a market order to sell 1000 shares the likely result would an average price of 126.86—1.5% lower than the best bid price.    Perhaps a market maker would step in to prevent this sort of carnage, but there are no guarantees.

Which brings us to rule #1:  Always use limit orders unless the security you are trading has narrow spreads and deep liquidity.

However things are not nearly as grim as they seem.  Unlike stocks, ETFs have built in processes to provide liquidity when needed.  This share creation / redemption process enables companies designated as Authorized Participants (APs) to routinely respond to  the market’s demand/distain for ETFs shares in 50K+ share increments.

For example, if market forces are causing a ETF’s price to drift higher than its net asset value (NAV), then an AP can step in and execute a profitable, essentially risk free arbitrage transaction that creates more shares.  The AP (and the ETF) are happy to create shares until the increased supply has driven the market price down close to the NAV value.  The reverse situation, with the ETF price below the NAV is also profitable for the AP to correct by redeeming shares.

This brings us to rule #2:  Know what the NAV value of your ETF/ETN before you trade.

The NAV value is available on Yahoo Finance by adding a “^” to the beginning of the symbol, and a “-IV” to the end.   For example the NAV symbol for VQT, is ^VQT-IV.  On Bloomberg add IV:IND to the end of the symbol to get, VQTIV:IND.  See the thumbnail below  for an example NAV quote.  You will probably won’t be able to buy or sell at the NAV price, but you should be able to get close.

NAV for VQT

Knowing the NAV value will help you recognize if the market is out of balance.  Normally the NAV will be close to the middle of the bid/ask spread—if not be especially careful.

If your trade is going to be large (e.g., 10,000 or more shares) you should work with liquidity providers like Wolverine, Knight, or Wallachbeth to see if they can facilitate your trade.   There is an excellent IndexUniverse  webcast that includes some demos of how these firms can provide great quotes for even million share transactions on lightly traded ETFs.

If your trade is small, say 100 shares or less, then a limit order should be fine.   If you want to score a few pennies on the spread you can try placing your order between the bid/ask price and see if it fills.  If it doesn’t execute you can cancel your order and  improve your offer until it does complete.

For larger orders things get a bit trickier.  I’ve tried “all or none” limit orders without much success.  What has worked for me  is a limit order set within the bid/ask price, biased a few cents in the market maker’s favor.  If I’ve specified a good limit price I will see partial fills in 100 share blocks over the span of a  minute or two until the order is complete.  You only pay your commission once, assuming the order completes within the trading day.  Of course there are risks to this; the market might move against you, or liquidity might be exhausted, but compared to the risk of a lousy price these are good risks to take.

And rule #3:  Even lightly traded ETFs typically have good liquidity, but it’s your job to coax it out. 

 

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A Covered Call That’s Long Volatility

Monday, January 30th, 2012 | Vance Harwood

Covered calls are an example of  positions that are short volatility.  I hadn’t thought of it that way until Sheldon Natenburg, the author of Option Volatility & Pricing  pointed that out in a fascinating interview in Expiring Monthly  (http://tinyurl.com/6wwplf9).   A covered call position is profitable if the underlying equity stays the same or goes up, but in a big market downswing, when volatility spikes up,  the modest potential profits from a covered call are more than wiped out by the losses in the underlying.

Unfortunately it is usually expensive to hedge a short volatility position.  The two most common strategies have problems:  VXX typically has roll yield losses, and VIX/VXX options have significant time decay.  Recently I started looking at Barclays’ VQT ETN, a fund that is intended to be long volatility.  The chart below compares $1ooo invested in SPY and VQT starting in September 3rd, 2010—VQT inception date.

$1k investment in SPY and VQT

In bull market phases VQT underperformed the S&P 500  by about 50%,  but during the -19.5%  drawdown in August 2011 VQT only dropped 3% before going on a short term volatility fueled binge that lifted it 20%.    The next chart shows the day-to-day percentage moves of VQT vs SPY since June 2011.

Daily percentage moves SPY vs VQT

When times are volatile, VQT shifts its investments to include more short term volatility—which lowers its correlation to the S&P 500 to about 50% or 60%.  In very quiet times, like the end of December/January VQT shifts to a almost pure S&P play—giving it the nearly 100% correlation you see at the right side of the chart.   The next chart is from the VQT prospectus, showing the backtested, theoretical performance of VQT since 2005

VQT vs S&P500 backtest to 2005

VQT looks almost tailor-made for covered call writing.  Its low drawdown behavior limits capital risk while its volatility is similar to the S&P 500.  Unfortunately there are no options available on VQT, so we’ll have to get creative in developing a covered call style position.  Since much of VQT’s composition is direct exposure to the S&P 500 I will use SPY options as logical building blocks.  A covered call is a short call position hedged with a long equity position.    Since brokers won’t accept a long VQT position as a hedge for a short SPY call and I don’t want to have naked calls, I’ll protect my short call position with long out-of-the-money calls—creating a call spread.     I’m not too concerned about losses on these credit spreads, because VQT is a natural hedge for the position, so I’m comfortable with a $2 spread in the option strike prices.

Profitability analysis:

Market Action VQT action SPY call credit spread action Overall Profit
S&P 500 strongly up Up, but not as much as S&P Worst case loss.  Loss is premium received at creation minus $2/ option pair Neutral to small loss
S&P 500 up Up, but not as much as S&P  Neutral to profitable, with profit equal to premium received at creation minus any in-the-money intrinsic value. Modest profit
S&P 500 down Down, but not as much as S&P  Profitable, keep full premium received at creation Neutral to small loss
S&P 500 strongly down Strongly up as volatility portion kicks in  Profitable, keep full premium received at creation Very Profitable

 

My opening position: with SPX around 1310,  I bought VQT at 128.82, sold SPY 3-Feb-12 call spreads at S132/S134 for net credit of $0.36.

 

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The beginning of the end for mutual funds

Thursday, January 26th, 2012 | Vance Harwood

The vibe of the IndexUniverse’s InsideETFs Conference in Hollywood Florida I attended this week was one that I have felt before—a group that knows they’re changing the very structure of their industry.  It’s not just about being new, creative, or disruptive—it’s the sense of knowing you have won.

The mutal fund industry is still almost 10 times the size of ETFs/ETNs with $7.9 trillion in assets vs $1.0 trillion, but their size isn’t giving them economies of scale in terms of fees or performance.   According to Matt Hougan, President of ETF Analytics, IndexUniverse the weighted fee cost of  mutual funds is 0.83% of assets, almost triple the 0.32%  of ETFs.  For mutual funds to become competitive on fees they would need to charge $40 billion less.  With regards to performance the numbers from 2011 indicate that 90% of the actively managed mutual funds underperformed their comparable passive indexes.

At the beginning of the end:

     The last of the old dominant players start moving from denial to adoption.

  • Fidelity has announced they will be offering a wide range of ETF products
  • In March PIMCO will start offering TRXT, an actively managed ETF that will  track their flagship Total Returns Mutual Fund

      Products using the new technology achieve broad acceptance

      Remaining structural/regulatory barriers to the new technology start falling

  • Most 401K plans ($2.5 trillion in assets overall)  do not offer ETF products, but because of  ETF’s lower expense structures this will change.

      The key benefits of the new technology are apparent to everyone

  • ETFs have lower fees compared to the mutual funds with similar strategies
  • The tax efficiency of ETFs is demonstrably superior, just 7.5% had capital gain payout in 2011
  • ETFs trade throughout the day and their makeup is transparent to the buyer
  • Alternative investment strategies are easier to implement (e.g., volatility as an asset class, risk on/off)

    The old businesses still in denial will shift from data based arguments to fear

 

Just like the mainframe computer, the mutual fund will never die.  Some investors will never see a reason to change, especially to something they don’t understand. Others will never buy due to fear—mutual funds have a history, unlike these new unproven things.  But ultimately greed will lead most investors to overcome their fears, and mutual funds will join vacuum tubes as a technology has-been.

 

 

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Betting on contango with OILZ and GASZ

Thursday, January 12th, 2012 | Vance Harwood

One of my primary goals is to invest where I have an objective edge.   There are many ways to try to get an edge, the two most common being:

  • Value investing—where you try to find companies that are currently undervalued, or likely to  grow their profits faster than expected
  • Technical analysis—where you use patterns or indicators to determine what a security will do next (e.g., head-and-shoulders, oversold / overbought)

Both of these approaches, in their standard usage require you to correctly predict a future price.  In June 2011 UBS introduced two new ETNs that get their edge by predicting that the traditional price differentials in futures contracts will be stable.  See this post (http://tinyurl.com/7f8fn3t) for details.  In theory these ETPs are not sensitive to the absolute price of the products (oil and natural gas)—they just need the term structure of the futures to stay close to their historical norms.

After six months that produced dramatic price moves in oil and natural gas, these funds are demonstrating they are insensitive to the commodity prices, and GASZ is showing a tidy 10% profit.  The charts below show the performance of OILZ and GASZ compared to popular ETNs that try to track the price of these commodities (USO & UNG).

Natural Gas: GASZ vs UNG

It looks to me like GASZ is a winner. The jury is still out on OILZ.  The price spikes on the charts are probably due to investors buying or selling when bid / ask prices were especially wide.  These products are lightly traded and require some research in order to set appropriate limit orders.

Disclosure: long positions in OILZ and GASZ

 

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Prediction: Dec 31,2012 S&P 500 close at 1418, up 12.78%

Tuesday, January 10th, 2012 | Vance Harwood

One forecaster has correctly predicted the S&P 500 year-end close within an average of 2% for the last 4 years:

Year End Estimated  Actual % Difference
31-Dec-08 879.82 903.25  +2.66%
31-Dec-09 1111.92 1115.1  +0.286%
30-Dec-10 1211.92 1257.88  +3.79%
30-Dec-11 1248.29 1257.60  +0.75%
31-Dec-12 1418.30    ??

 

This forecast is not from a  human, or a computer program—it’s the year-end closing value of the S&P from 6 years prior.   The chart below shows SPY (effectively 1/10 of the S&P) from 2003 to 2006 with SPY from 2009 to the present superposed on the same day of the month.

At the bottom I’ve shown the VIX index for these two different time spans.

I don’t believe patterns from the past are reliable in predicting the future.   It’s not surprising that markets recovering from crashes will show a similar trajectory, but since first seeing this pattern in November, 2009 I’ve been surprised at the close correlation.   This year showed the biggest divergence, with 2011 SPY going as much as 19% above the 2005 SPY and 10% below before moving back into synchronization.

One thing is clear—volatility since the 2008/2009 crash continues to be elevated.   I predict that the market in 2012 will not be for the faint of heart.

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Barclays XVZ as a market hedge—backtest to 2004

Wednesday, January 4th, 2012 | Vance Harwood

In August 2011 Barclays introduced XVZ, the first of a new class of volatility funds that focus on protecting investors against tail risk.  Tail risk events (or Black Swans as Taleb calls them) are the unfortunate tendency of markets to not behave like statisticians (or investors) would like them to.  Typically markets are well behaved statistically, with daily returns clustered around zero.   The chart below shows the behavior of the S&P compared to a Bell curve, or Gaussian  /normal distribution.

S&P daily returns

At first glance, the match looks good, with the primary difference being the S&P has more go-nowhere days than the normal distribution.  However the chart points out market spikes on both sides that don’t match the normal distribution at all.  The normal distribution predicts that 6 standard deviation (or 6 sigma) events should happen only in around once out of 2.5 million trading days (~ 12,000 years).  Instead we have had them multiple times in recent decades.   These long tail events wreck havoc on portfolios designed around the normal distribution.  Years of gains are wiped out in days…

XVZ is designed to hold its value until these negative outlier events occur, and then it switches into action, aggressively increasing in value as volatility indexes spike up during the crash.   Adding XVZ to your portfolio has the effect of buying insurance against crashes.   The open questions are how much does this insurance cost, and how much is needed to hedge your portfolio.   Backtesting XVZ, to see how it would have performed in the past helps us get a feel (although no guarantee) for those factors.

The VIX/VXV  ratio is the key driver for XVZ’s operation.  Unfortunately the CBOE only provides daily VXV (93 day implied volatililty) data back to December 2007 on their website.  This is a showstopper for direct backtesting before that time.    However, I wondered if the ratio of the daily nearest month VIX volatility future settlement value, divided by the 3rd month VIX volatility future might be a reasonable surrogate.   The next chart shows these two ratios compared.

VIX/VXV vs Nearest / 3rd Month VIX Futures settlement

Not bad.   The next chart shows my XVZ backtest simulation using the VIX/VXV ratio and the Futures M1/M3 ratio.

XVZ backtest vix/vxv and VIX futures M1/M3

Again, not bad.  Especially encouraging is the close match in the earlier 2007 timeframe, relatively quiet times that were similar to the 2004 through 2006 market action.  Using the M1/M3 ratio, which my VIX futures spreadsheet has back to March 2004, I obtain the following result:

It looks like XVZ would have been quiet in 2004 through 2007, serving its hedge function without losing value.  More recent data suggest that in quiet markets XVZ will lose some value due to increased contango on medium term volatilty futures.   Adding the VIX index and SPY as a surrogate for the S&P 500 we have a composite picture below that reinforces the notion that XVZ is a good hedge against market crashes.

Bottom line, by this simulation (ignoring dividends) a $300 investment in XVZ on March 29, 2004 would have protected (no net capital loss) a $1000 investment in SPY (market bottom March 6, 2009, $XVZ+$SPY = $1338) and returned 67% overall  (30-Dec-2011) compared to 11% for a SPY only investment.   A difference in compound annual growth of 6.8% vs 1.6%.

 

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Automatic dividend history generation

Wednesday, December 28th, 2011 | Vance Harwood

One of the services that I try to provide on Six Figure Investing is accurate ex-dividend and dividend history information for many of the popular ETFs.   Keeping this up-to-date can be a daunting task.

I’ve been experimenting with Google’s on-line spreadsheet documents, and I think I have created a way that you can generate the dividend history  (chart and data table) on any of iShares’ and SPDR’s ETFs—329 ETFs in all.   If it proves useful to viewers I will expand it to Schwab, and perhaps into Vanguard funds—provided I can obtain the information in a reasonable way.  The tool I have created is here.  Please let me know if you have problems with it, or suggestions on how I can make it better.

 

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iShare and SPDR dividend history

Wednesday, December 28th, 2011 | Vance Harwood
If the stock / ETF you are looking for is not an iShare or SPDR ETF then I recommend Dividend Investors website for dividend history information.

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