The Volatility Landscape—May 2013

Friday, May 3rd, 2013 | Vance Harwood
 

News

  • CBOE
    • The CBOE plans to extend VIX® Futures trading by over 5 hours—aligning with the London Stock Exchange open, and adding a 45 minute post settlement trading period 4:30 ET to 5:15 ET Monday through Thursday.
    • Two new volatility indexes, DLVIX and DSVIX are documented on the CBOE website.   These indexes were developed in cooperation with the French bank Société Générale and are now being used with two new European ETFs.   A quick look suggests these indexes switch VIX futures allocations based on term structure and VIX momentum.
    • Volume in VIX Futures continues to surge to record highs with April’s volume climbing 26% higher than March.  The year to year volume growth was 141%.   The chart below shows the open interest on the nearest 2 and the mid-term 4th through 7th month VIX Futures.
1MayVIX-Futures-OI

 

  • VIX Central improved its historical VIX Futures term structure graphs by switching the time axis from contract months to time to expiration.   This change greatly reduces the chances of misinterpreting term structure differences across contract expiration boundaries.  See this post for more information.
  • For the first time an inverse volatility fund—VelocityShares’ inverse short term volatility ETN XIV has taken second place in overall volatility fund assets under management (AUM) with $440 million.  The leader, Barclays’ VXX has $1.15 billion.  Third place goes to ProShares’ UVXY 2X short term volatility ETF with $344 million.  For more on inverse volatility see this post.
  • Yahoo finance now reports Exchange Traded Product (ETP) AUM as net assets in their standard quote information and has made some other information available (e.g. shares outstanding, total cash) with special tickers.   The topics and example tickers shown below for SPDR’s JNK:
    • Intraday Indicative Value   ^JNK-IV
    • Shares Outstanding   ^JNK-SO
    • Net Asset Value ^JNK-NV
    • Estimated Cash ^JNK-EU
    • Total Cash  ^JNK-TC
  • I recently found out about the Quandl data resource—a free source of downloadable price data  futures, stocks, rates, currencies, commodities; macro-economic data from FRED, BEA, DOE, Census, USDA, WB, UN, OECD; demographic and society data; and corporate financials.  There’s a lot of good stuff there.

 

Predictions 

  • With both UVXY and TVIX trading well below $10 per share the question of upcoming reverse splits has returned.
    • I expect ProShares to reverse split UVXY 10:1 in May or June—they don’t want to lose the momentum that they have built up.
    • The last time around (December 2012) Credit Suisse waited until TVIX had dropped below $1 per share before doing a reverse split.  With $188 million in assets, I doubt they’ll let this product fade into oblivion, but given their track record of procrastination I’m guessing we won’t see a reverse split until TVIX is South of $1—perhaps in October / November.

 

White Papers

  • “Easy Volatility Investing” by Tony Cooper
    • This paper took 2nd place in the National Association of Active Investment managers’ (NAIIM) recent Wagner Award contest.   It provides a good overview of volatility trading and then does a thorough evaluation of 5 different trading strategies for volatility products: buy & hold, momentum, roll yield, volatility risk premium, and hedged.
  • “Option traders use (very) sophisticated heuristics, never the Black-Scholes-Merton formula”   Haug & Taleb
    • I hadn’t seen this 2009 paper until recently.  Taleb claims that the practical impact of the Nobel Prize winning work of Black-Scholes-Merton on the options markets is significantly over emphasized.  He argues that structural relationships like put / call parity and compatibility between options combinations at various strikes (e.g., no negative butterflies) are the true forces setting options prices.
  • “Volatility Trading: Trading Volatility, Correlation, Term Structure and Skew” Bennett & Gil
    •  Over 200 pages of wide ranging information—from covered calls to exotic options, to links between CDS spreads and implied volatility.  Something for everyone.

 

Not Recommended:  XXV TVIX XVIX IVOP CVOL XVZ

  • I’ve added Citi Group’s CVOL and Barclays’ XVZ to my “Not recommended” list of volatility funds.
    • CVOL’s assets under management have dropped to $2.2 million and its bid/asked spreads are very wide.  Its strategy of trying to track volatility is sound, and their contango losses are less than UVXY or TVIX, but it’s just too small.
    • The intent of Barclays’ XVZ was to create a fund that was long volatility, but could be held during quiet times without losing much if any money.  XVZ attempted to do this by hedging a position in medium term volatility products with a short position in short term volatility.  Unfortunately for XVZ, the VIX Future term structure shifted about the time the fund was introduced in such a way that the hedging didn’t work and it has lost 30% in the last year.  XVZ might do OK during times of high volatility, but until it establishes some sort of track record in that environment I’d recommend staying away.   For more on XVZ there’s a good article “The Hedge That Wasn’t” posted by Season Investments.

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VIX Futures—Crystal Ball or Insurance Policy?

Saturday, April 13th, 2013 | Vance Harwood
 

Many people seem to believe that the CBOE’s VIX Futures market is attempting to predict upcoming CBOE VIX® values.  I think they are mistaken.   Most futures prices have very little to do with predicting the future.

Futures contracts were invented to allow producers/consumer of commodities to limit their business risk by locking in future prices.  In exchange for eliminating price risk they give up the potential for increased profits if markets later moved in their favor.  Traders wasted no time using futures for speculation, not because they somehow foretell the future, but rather because the low margin requirements for futures allows them to heavily leverage their bets.

Prices for futures contracts are constrained by arbitrage.  For example, if an arbitrager sees the premium for Dec 2013 E-mini S&P 500 futures rise above a certain point they will short E-mini contracts and buy the appropriate amount of stocks in the S&P 500 (or just short SPY).  From this point on they don’t care what direction the market moves—they are perfectly hedged—a risk free position.  The transaction is triggered when there is sufficient difference between the current S&P prices (the “spot” price) and the December contract bid price to compensate for their cost of capital to buy the stocks, account for dividends, and deliver the target profit.  Alternatively, if they think the futures price is too low, they reverse the transaction, buying the future and shorting the S&P 500.   Companies will differ in how much premium they require between the spot price and the futures price but the net effect is that E-mini prices trade between these boundaries—they aren’t a divination of the S&P 500’s value in December 2013.

For physical commodities like corn or natural gas the cost of storage is included in the futures pricing and in some cases seasonality.   For example, prices for corn might be depressed during harvest time because some producers want to move the product directly to market so they don’t have to store it.

Arbitrage for VIX futures is a much trickier thing.  You can’t buy volatility on the spot market and store it in your garage for a few months.  The best you can do is buy or sell the appropriate set of S&P 500 (SPX) options—the ones that expire 30 days after the settlement date, and eventually subject yourself to the settlement process.  Settlement is via the tweaky Special Opening Quotation (SOQ) process, which can’t even tell you ahead of time the full set of options that will be used for the settlement and in the last year has differed from the VIX opening price by as much as +4.27% / -3.8% on the morning that VIX Futures settle.

Contiguous SPX options are only available for the next 4 or 5 months, so the options associated with further out VIX futures expirations (up to 9 months out) are sometimes not even available.   Clearly market makers in VIX Futures must have other ways to hedge their positions (e.g., VIX futures spreads, VIX options, calendar spreads of SPX options).  In fact with the recent CBOE announcement of plans to start VIX futures trading 5 hours earlier than the current 8:15 ET, to coincide with European trading hours it appears they don’t even need the S&P 500, SPX options, or the VIX  to operate their market—at least for a few hours.

A quick look at historical data suggests that VIX futures tend to trade at a 3% to 9% premium to the VIX level of their associated SPX options.  A chart with April 10, 2012 and April 11, 2013 data is shown below:



Since the notional value of the SPX options market is currently much bigger than the VIX futures value it is reasonable to assume that the VIX futures tail does not wag the SPX options dog.   So the question becomes, what sets SPX options prices, and indirectly their implied volatility?  Are the market participants seers or are there other factors at work?

First of all, by any measure SPX option implied volatility is terrible at predicting future volatility in any way other than general reversion to mean.  If current volatilities are very low they predict an increase in volatility, if really high they predict it will drop.  Short term they predict that tomorrow will be like today—brilliant…

Insurance is a better model for predicting SPX option prices.  Investors use option strategies for price protection (e.g., fully hedge any market moves below a certain price), and as assets that reliably go up during serious market corrections or panics.  Even if your puts aren’t in-the-money, they still go up a lot when volatility spikes.

An insurance company doesn’t try to predict when you will have losses on your house or car.  It looks at the statistics and then charges a constant monthly rate they believe in aggregate will cover the claims they receive and over time deliver a reasonable profit.   I think the VIX Futures market looks a lot like an insurance provider.

Two final notes:

  • VIX Futures do have one seasonality pattern —the Christmas effect.  Typically December VIX futures are slightly cheaper than the surrounding contracts because volatility around that time tends to be low—a lot of people are on vacation, and the market is closed for several holidays
  • The VIX Futures term structure chart during quiet markets has gotten more linear in the last couple of years.  This shift has dramatically increased the contango in the mid-term futures—much to the chagrin of the XVIX, VXZ, and XVZ ETNs. On the other (inverse) hand ZIV is a happy camper.   Eli, from VIX Central speculates the curve straightened because there used to be a low risk trade of shorting a VIX future month right before it started sliding down the steeper portions of the curve, while being long the month after it as a hedge.  This trade might have just gotten crowded or perhaps the increased volume in the later month futures driven by the volatility ETPs made the market more competitive.

 

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When the Term Structure Chart Lies to You…

Thursday, May 2nd, 2013 | Vance Harwood
 

Update:  VIXCentral has enhanced their historical term structure graphs to use days to expiration rather than months for the time axis of the charts.   This change eliminates the distortions that I wrote about in the post.   VIXCentral’s historical charts now look a lot like the Excel charts that I generated for this post.

Term structure graphs, like the VIX® future charts on VIXCentral.com are very useful.



At a glance you can see futures prices for multiple months and determine whether the market is in backwardation or contango.  The slope of the curve gives a quick estimate of how much roll yield you can expect at various parts of the curve—assuming the market mood stays the same.

However some subtle errors sneak in if you aren’t careful.

A typical term structure graph has prices on the vertical axis and calendar months on the horizontal axis.

However futures typically don’t expire on month boundaries, so sometime in the current month futures expire, to be replaced by next month’s as the near term futures.  Nothing on the chart indicates this.  It’s kind of like the chain on your bike skipping a tooth—if you’re not paying attention you might not notice.   In the chart below it appears that on March 20th, 2013 the term structure shifted up almost 1.5 points for most months.

VIXCentral

VIXCentral


But on the morning of the 20th the March futures expired, so all the futures shifted to the left by one on the chart; the “April” price point on the 19th, became the “March” price point on the 20th.   The chart below gives more detail.

Excel-Cal-Mar19+20


The next chart tells the real story of what happened to the term structure between the 19th and the 20th.

Excel-Contract-Mar19+20


The short term portion of the term structure shifted down significantly, and the mid-term futures (July through Oct) barely moved.  Whenever comparing curves be wary when you cross contract expiration boundaries.

I ran into this problem when evaluating the performance of VelocityShares’ ZIV from March 5th through April 3th, 2013.  The contango on the mid-term futures that ZIV shorts had been steady at around 3% per month since March 5th, however after almost a month ZIV was only up 0.17%.   At first I thought it might be volatility drag, because there was a fair amount of chop during that period, but looking at the non-inverse ETN VXZ—it was only down .55% for the period, so if there was volatility drag it wasn’t significant.  A look at the calendar based term structure below showed a mid term curve that shifted up strongly over time, suggesting that ZIV should have lost much more than it did.



But this curve is comparing apples and oranges—the April data point has March futures combined with April expiration futures.   Correcting for that we get the curve below:

ZIV-Contract TS



Now we see why ZIV hasn’t moved.  The July/Aug/Sep/Oct futures contracts it holds have barely moved from last month’s values.   The contango in the term structure has been cancelled by a general rise in prices.

When comparing term structure curves between dates be careful.  If you span expiration dates the comparison is probably lying.

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Short Volatility on a Roll

Monday, April 1st, 2013 | Vance Harwood
 

Investors betting on the next volatility spike have taken a beating.

The last time the CBOE’s VIX® index closed above 30 was December 8th, 2011.  In the 16 months since the split adjusted price of Barclays’ VXX has dropped from 174.84 to 20.34—an 88% drop.  None of the 14 other USA based volatility funds that are designed to rise with volatility increases did well, the best being Barclays’ VQT, which eked out a 5.5% gain—while the S&P 500 went up 26%.

The worst of the short volatility funds, Barclays’ XXV went up 21%, the best, VelocityShares’ XIV went up 326%.  This sort of performance gathers attention and assets—XIV is now the second biggest volatility fund with $421 million in assets.   ZIV, VelocityShares’ mid-term inverse fund quadrupled its assets from $10 million to over $42 million.  The chart below shows the assets under management of the current 20 volatility funds—the green bars are 27-March-2013 numbers.

Vol ETP AUM

Data from IndexUniverse



Buying XIV or ZIV isn’t the only way to short volatility.  Not counting investing directly in VIX futures there are at least four different ways to go.

The most obvious strategy is to just short one of the long funds.

Direct Short (VXX, UVXY, TVIX, etc.)

  • The primary advantage is that there is no compounding errors or path dependencies.  It doesn’t matter what price path these securities follow, the end result of the position will be the same.  However there are a host of disadvantages.
  • Losses can be much greater than your initial investment. If a volatility spike comes along (and they tend to be fast), you can get in trouble in a hurry.  No respecter of  market hours,  the volatility climate can change overnight.
  • These shares are usually hard to borrow—other people have the same idea
  • You can’t short shares in an IRA account
  • The best you can do with your initial position is a 100% gain (security goes to zero).  To get more than 100% gain from your initial position you need to short more shares.
  • The leverage factor is not in your favor.  After starting with a leverage of 1X when you place the short, the leverage goes below one if the security drops in price, and above one the security moves against you.

To address investors that can’t / won’t short, or don’t want to babysit their positions as closely Exchange Traded Products (ETPs) are attractive.  There are two different implementations:

  1. Daily Resetting Inverse Funds (XIV, SVXY, ZIV)
    • The primary disadvantage is compounding errors.  If the security thrashes around a lot your position will drop if value even if the long side ends up right back where it started.   However, there are a lot of advantages.
    • You can’t lose more than your initial investment.  The fund might terminate, but it won’t go below zero.
    • The leverage is a consistent 1X and your profits are unlimited—the daily reset sees to that.
    • They are easy to invest in.  There’s no problem using these in most IRAs.
    • In trending bull markets these funds can do better than their leverage factor.
  2. True Short Funds (XXV, IVOP)
    • The primary advantages of these mostly forgotten Barclay funds is that they do not have compounding errors and you won’t lose more than your original investment.  There are a lot of disadvantages.
    • Your maximum profit is less than 100%, probably much less, because these funds can’t go higher than $40 per share.  There’s a feature…
    • Like a true short, these funds have variable leverage.  When things are going bad for you the leverage gets higher.  Because of this accelerating leverage these types of fund are prone to termination events (IVO), or get dangerously close (IVOP).

At first glance, options are the ideal approach for shorting volatility.  They have no compounding error, limited downside, good leverage, and reduced capital costs.  The bad news is that Wall Street knows this, so profits are tough to come by.

Option Strategies (VIX options, options on VXX, UVXY, SVXY, etc.)

  • For an option based strategy you should figure out how much movement you need in the underlying before your position breaks even.  Obviously things like time to expiration and implied volatility complicate this analysis, so I usually start with the easiest case—position value at expiration.
  • For example, consider a long put on UVXY using data from 6-Mar-2013:
    • UVXY is at 9.47 and the Jan 2014 puts (318 days), with a strike price of 9 are selling for 4.55.
    • The prices on the puts look reasonable; the IV is around 150 which is a pretty good match to the 22 day historic volatility which is running in the mid-150s.
    • For this trade the UVXY break even point is around 4.55—in January 2014.
    • Obviously just breaking even isn’t enough. To get a good profit, say 80% of your investment you need UVXY to drop another 3.64 points, down to $0.81, a 91% decline.  That’s certainly possible, even likely for UVXY—unless the market has bearish period during 2013.  UVXY can really skyrocket during a sustained correction, so if something similar to the 2010 Flash Crash, or the 2011 Euro worries happens you would be lucky to break even.
    • Bottom line, if you’re buying puts you’re probably not minting money.  Of course if you predict a period of low volatility correctly then you’d do great, but just randomly buying puts will probably not work that well.  If you think you are going to average down your basis during spikes by buying cheap puts then you might be surprised. The prices on the low strike puts will stay surprisingly high because their IV will spike too.
  • No sane person would write naked calls on a long volatility product, but spreads could be used to harvest premium and limit potential losses.   The big problem here is call skew—the IV of the calls rises rapidly with the higher strikes.  Again, Wall Street is ahead of the game and to get interesting profits you’d have to go with wide spreads, increasing your risk considerably.

Eventually there will be another volatility spike that will slam short volatility positions, but predicting when that spike occurs will be tough—and it might be years off.   The current set of long volatility products get killed by contango during the 75% of the time that things are quiet, until that changes I think investors are going to be much more successful going short volatility—bailing out when the market gets nervous.

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How Meaningful are VIX’s Big Percentage Moves?

Saturday, March 23rd, 2013 | Vance Harwood
 

The last few weeks there have been some eye popping percentage moves in the CBOE’s VIX® index—these moves generated lots of headlines .  As an antidote to the hype a few savvy VIX followers noted:

 “Remember that $VIX is already a percentage.”   Jared Woodward from Condor Options

“The $VIX was up 2.08% today, NOT 18.5%”  Mark Sebastian from Option Pit .

I have to admit that my brain spun a bit on Jared’s percent of a percent observation.

Yes, the VIX value is already a percentage—formally it’s an estimate of what volatility will be over the next 30 days that’s scaled up to be a full year’s forecast.  So if the VIX is at 11.38 then the forecast is that the S&P 500 will fluctuate within +/-11.38% over the next year.   Just like a weather forecast there’s also an estimate of how likely this forecast will be correct—in the case of the VIX it is always the same number—67%.

The VIX jumped 2.06 points from a close of 11.38 on 15-March-2013 to 13.36 on the 16th—that’s an impressive 18.5% move.  But the annualized forecast only changed to +/- 13.36%—not something to hyperventilate about.

Percentages are useful for evaluating changes.   If I say that XYZ stock is up 5 points it doesn’t mean much to the listener unless they know the starting point or basis.  Is it a $10 stock, or a $505 stock?  If I report XYZ’s increase as a percentage (e.g., 100% or 1%) I present a clearer picture.

The VIX index is not like a normal stock—it won’t go to zero, and it tends to drift or revert towards a middling value (median of 19.05).  The chart below shows the 5847 VIX closing values between 2-Jan-1990 and 20-Mar-2013 summed in 0.1 wide bins between 5 and 85.

VIX-histo-a



What an ugly distribution!  Don’t try to use your typical statistical tools (e.g., mean, standard deviation) on this beast!  In the last 13 years the VIX has dropped as low as 9.3 only once, but it has closed between 11.1 and 11.2 thirty-nine times.   During that time span it has only closed over 50 fifty-six times (0.96%).

Are the recent big percentage moves an indication of high market fear or is it more likely due to the VIX recently revisiting 5 year lows?   With low values of the VIX a big percentage jump only requires a relatively small point move (e.g., A 3 point increase on a 10 point basis is +30%).

Pursuing that question I plotted the maximum positive and negative percentage  daily swings in the VIX against the VIX value itself.

Per VIX moves

 

Not surprisingly the  min/ max percentage moves do increase as the VIX level decreases.  The next chart shows the min / max point moves (not percentage) in the VIX.

VIX pt moves

 

VIX values between 10 and 40 tend to have maximum moves in the +3 / -2.5 range, it doesn’t seem to matter much what the starting value of the VIX is.

Bottom line, history suggests that unless the VIX moves more than +/- 3 points nothing particularly noteworthy is happening.

On the other hand, if you are trading in VIX futures or volatility exchange traded products like VXX, UVXY, CVOL, TVIX, or XIV (full list) you do care about VIX percentages.  Big VIX percentage moves usually aren’t matched by these products, but the leveraged products (UVXY, CVOL TVIX) often do a respectable job of tracking the big short term VIX moves.

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