Since the CBOE’s introduction of Weekly options, our opportunities to take advantage of expiration day dynamics have quadrupled for many stocks/indexes.  Depending on your position, it is fascinating/horrifying to watch the premium collapse on options in their last couple hours of trading.    Jeff Augen in SFO weekly has written an interesting article (New Approach to Trading on Expiration Day) on some of the underlying mechanisms behind the last day dynamics.

He points out that when a stock moves above a strike price (e.g., 380 for AAPL) on expiration day, covered call writers with just now in-the-money calls are motivated to close out their positions, as well as those long the calls.  The bid price on the options can be low enough that large scale option holders often prefer to exercise their options and sell the stock to close out their positions.   The combined selling pressure from these processes can mute, or even reverse an upswing in a stock.

There are quite a few conservative investment strategies that deliver a good return if the underlying security doesn’t move much.   Covered calls and dividend collection are two that come to mind.   These strategies are conservative in the sense that they don’t require the security to go up in order to be profitable—in fact a stable price is just fine.  However, if the market tanks, both of these approaches can subject the investor to big losses that far outweigh the profits they offer.   Investing in volatility is an attractive way to hedge away this downside risk, because volatility usually goes up when the market goes down.   Usually is the operative word.  These last two weeks were an example of when this correlation fails.

Hedging the S&P with volatility, click to enlarge

The chart above tracks percentage changes since the first of December for SPY and two popular measures of volatility, the non-investable VIX, and VXX, which is one of the most popular ways to go long volatilty.  SPY ended up down 2.7% and both volatility measures went down over this period—a lot.  Not much of a hedge.  I’ve included the nearest two months of VIX volatilty futures to show that it is not just contango that is driving VXX down, the underlying futures dropped too.

One volatility ETN didn’t drop.   Not only did XVZ, Barclays’ Dynamic VIX fund go up, it went up about the same percentage as SPY went down—2.5%.

Hedging S&P --XVZ?, click to enlarge

XVZ has only been around since August 18, 2011 so our price history is pretty limited. The chart below shows the results of investing $1K each in SPY and XVZ, SPY and VXX, and $2K in just SPY.

$2K investment since Aug-11, click to enlarge

The SPY+XVZ combination is noticeably less volatile, with a standard devation one third of the others: 22 vs 75 and 78.   However five months is a really short time to judge a strategy like this, so I expanded the backtest a little, back to January 3, 2011 using my XVZ simulation.

XVZ hedge for S&P 500 through 2011, click to enlarge

This chart illustrates two other characteristics of XVZ.  It is designed to capture big volatility jumps, like the one in August, and hold onto them once they occur. And it too suffers from contango (first half 2011)  if it is severe enough—although it was minor compared to what happened to VXX.

Clearly XVZ is not a perfect mirror of the S&P 500, but its behavior when volatilty spikes makes it even more attractive than a pure hedge. Market panics are not predictable, and having a workable hedge that turns a panic into an opportunity is intriguing.

SPY went ex-dividend Friday the 16th, so it is too late to buy the security and still receive this quarter’s dividend.  The dividend payout will be $0.7701 per share on January 31st, 2012.  Yes, SPDR is in no hurry to distribute the  $530,000,000 (!) in dividends that it collected last quarter for SPY.

For more information about SPY’s dividend and its sister ETFs IVV, and VOO see this page.

For general information about dividends (e.g., interactions with stock price, their interactions with options) see  Top 10 questions about dividends.

IEF, Barclays’ 7-10 year treasury ETF has been trading in a 102 to 105 range since October.  When the market is down it has been trading near 105.  I put a call credit spread in place, betting that IEF would stay below that 105 level for the rest of this week.  I sold S105 calls and bought S106 calls for a net credit of $0.20.   My offer at the time was close to the mid point between the asked and bid prices.

IEF, click to enlarge

In December 2010 UBS came out with XVIX—an ETN that holds a long position in medium term volatility (essentially equivalent to VXZ), and short a 50% position in short term volatility (essentially equivalent to VXX).  See Volatilty Tickers for the full set of available ETNs from Barclays, Citigroup, ProShares, UBS, and VelocityShares.    XVIX’s strategy was to take advantage of the typical situation where short term futures are eroded by contango and protect the investment against volatility spikes with the medium term long position.    The product backtested great, showing returns of 24% and 55% percent in 2009 and 2010 respectively.

Since its introduction at $25 XVIX has mostly drifted and is down 11% almost a year later. Since VXX and VXZ are very close to the values they had a year ago it isn’t surprising that XVIX is fairly close to its initiation value.  What is surprising is that XVIX did nothing when VXX was down over 50% earlier this year.

XVIX compared to VXX & VXZ, click to enlarge

At least one of the reasons for XVIX’s poor performance is that the term structure of  medium term volatility futures shifted in 2011.  In the graph below, negative percentages indicate that the futures are in contango, positive numbers indicate backwardation.

Contango on medium term volatility futures

Even though VIX in the Summer of 2011 dropped below 15 and VXX dropped almost to 20 the medium term futures stayed in contango. Perhaps it doesn’t explain all of XVIX’s poor performance, but it certainly was part of it.    The next chart adds the short term contango over the same time frame scaled so that the maximiums / minimums are about the same.  The contango / backwardation on the short term 1 / 2 month futures is typically about 5X larger than the medium term equivalent.

Medium term futures contango with normalized short term contango, click to enlarge

While the behavior of short term contango has stayed about since the beginning of the bull market in March 2009 the contango of the medium term futures has tended to increase, with the average value in 2011 being more negative than 2010. This looks like a structural shift in the term structure and it isn’t good news for XVIX. Unless UBS amends its mix of medium and short term futures, it looks like XVIX will be a long term loser.

If you are interested in downloading the data used for this analysis, see this post.